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The relatively attractive income—and relatively low historical volatility—provided by bank loans, and the floating-rate funds that invest in them, has, not surprisingly, continued to attract investors throughout 2013. June brought the string of consecutive weekly inflows for floating-rate funds to 54 and the total year-to-date inflow to nearly $32 billion, according to JP Morgan research.
As the second half of 2013 unfolds, however, bank loan investors may have questions regarding the economic environment, the prospective withdrawal of monetary easing by the Federal Reserve, and the effect on loan rates should the Fed begin to hike short-term interest rates. Here, we try to answer those questions.
1) Do consensus economic expectations provide a favorable backdrop for loans?
Consensus forecasts issued by the International Monetary Fund, the Congressional Budget Office, and the Blue Chip survey of economists put U.S. gross domestic product growth at an average of 1.6% for 2013, 2.7% for 2014, and 3% or more for the following three years.1 Such gradual and sustained improvement in the economy should benefit lower-rated companies and their bank loans as investments.
But even if the economy falls short of these forecasts, recent performance of bank loans in weaker economic environments has demonstrated their resilience as an asset class. Despite annual fears of recession in recent years, and current economic growth rates lower than expectations for 2014, default rates on loans have remained well below the historical average of 3.5%, according to JP Morgan research. The research also revealed that the par-weighted default rate was 1.3% in June, and is expected to remain below 2.0% in both 2013 and 2014.
Even mild improvement in economic growth to above 2.0% should further advance the economic health of these companies. To the extent that economic growth improves as forecast, or gets even stronger, companies should enjoy faster revenue growth, improved earnings, and better balance sheets. As long as growth continues on this track, bank loans seem poised to continue to provide relatively attractive income, stable principal and historically low defaults.
2) If the Fed begins "tapering," how will it affect bank loans?
Tapering, or the prospective reduction of Fed purchases of long-term U.S. Treasury debt, would have its most direct impact on long-term high-quality securities—i.e., the actual issues that the Fed is purchasing under its quantitative easing program. Bank loans are exactly the opposite of what the Fed is buying: short-term, lower-rated securities. The initial reaction to the prospect of Fed tapering was investor redemption of nearly every asset class, including Treasuries, equities, and high yield under the justification that less Fed liquidity meant the absence of support for all assets.
Although investors soon realized there was likely little impact on investments other than longer-term Treasuries, even during the initial panic response to tapering, loans performed relatively well. For example, in June, the JPMorgan Leveraged Loan Index outperformed high-grade bonds, the 10-year Treasury, and emerging market bonds by 199 basis points (bps), 203 bps, and 441 bps, respectively, according to JP Morgan research.2 For the first half of 2013, positive performance of 2.3% for leveraged loans compared favorably to negative performance of high-grade bonds (-3.0%), the 10-year Treasury (-4.9%), and emerging market bonds (-8.27%), according to JP Morgan.3
Fed tapering, when it is executed, likely will exert additional downward pressure on prices of longer-dated Treasury securities, but there seems little evidence that bank loans would be affected similarly. In fact, if Fed tapering is predicated on stronger U.S. growth, the credit improvement implied by a more robust economy could make bank loans even more attractive as the financial metrics of borrowing companies improve with the economy.
3) If the Fed raises short-term rates, will the yield on LIBOR-based bank loans also rise?
Bank loan rates generally float as a spread over the London Inter-Bank Offered Rate (LIBOR), not as a spread over the fed funds rate. So if investors expect higher rates on bank loan portfolios when the Fed raises the fed funds rate, they may breathe easier knowing that LIBOR rates are well correlated with the fed funds rate—that is, they tend to move in the same direction. Chart 1 should provide investors some comfort that, historically, there has been a strong correlation between the three-month LIBOR (the rate frequently used as a basis for loan rates) and the fed funds rate. Differences have appeared only occasionally.
Effective fed funds rate, three-month LIBOR (based on U.S. dollar), and bank prime loan rate, January 1986–June 2013
Source: Federal Reserve Bank of St. Louis.
For illustrative purposes only and does not reflect the performance of any Lord Abbett mutual fund or any particular investment.
While this correlation seems to assure investors a basis point-for-basis point increase in their bank loan portfolios, the "floor" on many bank loans of 1.0% or 1.5% will delay that adjustment from today's extraordinarily low rates until that floor is exceeded. A floor limits how low the loan rate can go by stipulating a minimum level or floor upon which to calculate the loan rate. For example, if the loan rate is set at LIBOR plus 4.0%, LIBOR is at 0.2% and if the loan has no floor, the rate will be 4.20%. However, a floor of 1.0%, means that the rate will be 5.00%, not 4.20%. Thus, as LIBOR drops below 1.0%, the floor is activated and yields do not drop as low as might be expected. This is the case today with many bank loans; a floor has prevented lower rates on bank loans. Conversely, as rates rise the adjustment to the bank rate will be delayed. The bank loan rate will not increase until LIBOR exceeds the floor, or 1.0% in our example.
While this may seem disappointing to investors during the initial phase of rising short-term interest rates, an alternative perspective is that loans have been paying relatively wider spreads compared to alternatives when interest rates were extraordinarily low, and the yield was that much more valuable. However, once short-term interest rates rise enough to exceed the floor, additional increases are likely to be matched with increases in the bank-lending rate. To the bank loan investor, this would mean a higher yield.
Risks to Consider: 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. Bonds may also be subject to call, credit, liquidity, and general market risks. 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. Lower-rated bonds may carry greater risks than higher-rated bonds. Floating-rate loans are lower-rated, higher-yielding instruments, which are subject to increased risk of default and can potentially result in loss of principal. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan's value. High-yield securities, sometimes called junk bonds, include increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. No investing strategy can overcome all market volatility or guarantee future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
The bank loan market may not perform in a similar manner under similar conditions in the future.
Yield is the annual interest received from a bond and is typically expressed as a percentage of the bond's market price.
Gross domestic product (GDP) is the total value of all the goods and services produced within a country's borders. When that figure is adjusted for inflation, it is called the real gross domestic product, and it's generally used to measure the growth of the country's economy. In the United States, the GDP is calculated and released quarterly by the Department of Commerce.
A basis point is one one-hundredth of a percentage point.
The default rate measures the percentage of issuers in a given asset class that failed to make scheduled interest or principal payments in the prior 12 months. The default rate can also be par-weighted, meaning that it measures the dollar value of defaults (based on par value of issued securities) as a percentage of the overall market.
The London Interbank Offered Rate, or LIBOR, is a short-term interest rate that banks charge one another and that is generally representative of the most competitive and current cash rates available. 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 JP Morgan Leveraged Loan Index is a market value-weighted index designed to represent the investable universe of the U.S. dollar denominated leveraged loan market.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
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.