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As investors brace for the possibility of higher interest rates, they have sharpened their focus on floating-rate loans. And the heightened interest has been accompanied by the reemergence of some market attributes that may raise questions of how the market has evolved in terms of its ability to provide investors with an effective interest-rate hedge and positive real yields.
Investors' demand for yield can cut two ways as it relates to credit quality. The ability for companies to issue attractively priced debt has allowed them to extend their debt maturities and refinance existing liabilities. This increased flexibility has been accompanied by rising profits, resulting in an expected default rate of less than 2% in 2013 and in 2014, which would remain well below the long-term average of 3.8%, according to J.P. Morgan.1
From an asset management perspective, the refinancing trend and the fact that loans can be called by the issuer at any time means that loans rarely trade at significant premiums to par, such as has occurred in many bond markets in recent years. While this aspect can support the yields on loans, managers are frequently facing refinancing or re-pricing scenarios, where they need to decide whether they still like the issuer at the new yield. If not, they may choose to sell part, or all, of a position.
The other side of companies' ability to issue inexpensive debt is that they may be inclined to assume more leverage, which could gradually weaken their credit quality. While corporate debt levels have been rising, they remain significantly lower than the levels at the height of the financial crisis. (See Chart 1.)
Source: J.P. Morgan.
* EBITDA stands for earnings before interest, taxes, depreciation, and amortization.
For illustrative purposes only and does not depict any Lord Abbett mutual fund or any particular investment.
However, the increase in leverage appears to have come from an increase in capital expenditures as they rose by 9% in the fourth quarter of 2012. Rising capital expenditures could be considered to be a constructive use of debt when, for example, compared to financing special dividends to private equity investors. And this latter use of proceeds still remains rare, with only 3.3% of the total loan volume in the first quarter of 2013 heading toward dividends, compared with 7.6% of the transactions in 2007.
The strong demand for floating-rate loans also has facilitated an increase in "covenant lite" offerings, which, among other factors, provide fewer protective clauses for investors in terms of overall debt levels or asset sales. Although covenant lite issuance recently increased, borrowers still appear focused on achieving the lowest cost of capital rather than egregiously loosening covenants.
While investors may be concerned that further increases in covenant lite loans could lead to an abundance of over-leveraged companies, U.S. banking regulators recently proposed guidelines for sound leveraged lending and underwriting practices. These principles could prevent a repeat of the widespread deterioration in underwriting standards that was observed throughout the capital markets prior to 2008.
Collateralized loan obligations (CLOs) have also recently reemerged in the floating-rate loan market, and these structured products can have multiple implications. Overall, the presence of CLOs can add to the demand for loans, and their presence in the market has been reflected by the $34 billion in CLO issuance as of mid-May 2013, which was more than four times the amount from a year ago.
On the other hand, CLOs may not be the most discriminate buyers because they have to invest substantial amounts often under time constraints. This broad demand provides the opportunity for active and astute portfolio managers to sell loans to CLOs at prices that may be above the manager's estimates for fair value.
Another difference in the current loan market compared with the pre-crisis environment is the prominent risk that investors may face within the debt capital markets, which for most investors is the threat of rising interest rates. And in this environment, investors should recognize the role that LIBOR2 "floors" may play within the asset class. These minimum interest rates, which were recently around 100 basis points (bps), can support an attractive level of loan income in the low-yielding environment. Considering that LIBOR was about 30 bps as of mid-May 2013, these floors mean that investors may benefit from attractive yields today, but might not see higher coupons until rates move about 70 bps higher.
While investors may be disappointed at the delay in increased income, loans should maintain price stability, since it is estimated that loans could generally lose less than $1 in price due to an increase in short-term interest rates.3 Meanwhile, the floors do not change the minimal durations on loans, and they could also remain relatively stable with an increase in long-term interest rates that may cause particularly severe volatility in long-term bonds with high credit quality.
Although the floating-rate loan market has reacted to investors' rising demand for the assets, the recent changes involving leverage levels, structured products, and issuance trends should not compromise the prevailing attributes of the asset class. Thus, in a low-rate environment where interest-rate risk may be a looming threat, the potential for relative price stability and positive levels of real income should continue to provide value to investors.
A Note about Risk: Investing involves risk, including the possible loss of principal. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Fixed-income securities may also be subject to call, credit, liquidity, and general market risks. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan's value. The interest rates on senior loans adjust periodically and may not correlate to prevailing interest rates during the periods between rate adjustments. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Leverage, including borrowing for investment purposes, may increase volatility by magnifying the effect of changes in the value a holding. The use of leverage may cause investors to lose more money in adverse environments than would have been the case in the absence of leverage. No investing strategy can overcome all market volatility or guarantee future results.
Bonds are categorized by quality, and bond quality is related to the return investors expect to receive on a bond. In general, the lower the quality of the bond, the higher the return an investor expects to compensate for the risk of the bond defaulting.
Glossary of Terms:
Par is the face value of a bond when it is issued.
Collateralized loan obligations (CLOs) are structured products consisting of tranches of varying levels of subordination.
In this instance, fair value represents an opinion about where the value of an asset should be priced given its fundamentals.
A basis point is one one-hundredth of a percentage point; 100 basis points equals one percentage point.
Coupon is the interest rate on a debt instrument as a percentage of its face value, or par.
A debt-to-EBITDA ratio is a leverage metric that can indicate the ability of a company to service its debt.
LIBOR is an interest rate that banks can borrow from one another in the London interbank market. The rate is set daily by the British Bankers Association. A LIBOR floor is the minimum interest rate on a debt instrument. The floor and the credit spread may comprise the yield on an instrument.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.