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Fixed-Income Insights

In the wake of U.S. money-market reform in 2016, how have changes in the benchmark London interbank offered rate affected bank-loan investments?

 

In Brief

  • Last year, U.S. bank loans attracted investor interest in anticipation of U.S. money-market reform, which was expected to help boost interbank borrowing, and, thus, underlying interest rates on loans.
  • And yet, despite their relatively attractive performance over the past 12 months, bank loans have not provided what many investors were expecting: rising income.
  • What happened? While LIBOR has increased, bank-loan yields actually have declined.
  • The bulk of the reduction in yield and spread relates to repricing and refinancing of loans by borrowers, which has more than offset the rise in LIBOR since the beginning of 2017.
  • Many borrowers were able to  reprice their loans at a narrower spread over LIBOR. The end result for investors was that they realized lower-than-expected income on loans.
  • It appears that repricing activity will continue in the months ahead, though at a reduced rate.
  • Meanwhile, if tax reform, reduced regulation on U.S. businesses, or improved global growth lead to a stronger U.S. economy, the bank-loan sector could benefit.
  • The key takeaway: With relatively attractive current income and other potentially beneficial attributes, bank loans likely will continue to provide an effective fixed-income alternative. 

 

A year ago (July 2016), it became apparent that pending U.S. money-market reform would pressure financial institutions away from traditional financing options and toward increased interbank borrowing, pushing higher the London interbank offered rate (LIBOR). Investments based on this widely used benchmark attracted investor interest in anticipation that higher LIBOR, supported by rising short-term rates, would boost interest payments on linked securities such as bank loans. A portfolio of bank loans with rates that would respond to a rising fed funds rate (the U.S. Federal Reserve [Fed] had signaled additional rate hikes after its December 2015 tightening move) seemed to offer potential for rising income. At the same time, the three-month rate reset feature of the most popular variety of LIBOR investment offered the potential for stability of principal in a rising rate environment.

With the Fed intent on rate normalization, and the U.S. economy persistently growing at about 2%, bank loans seemed ideal for an environment of stronger growth and rising rates. After the November 2016 U.S. presidential election, the prospect of fiscal stimulus offered further support for the bank-loan asset class by potentially reducing default risk through expected stronger economic growth.

How has the abovementioned LIBOR scenario played out since last summer? As investors had expected, LIBOR rose, the Fed pushed up short rates gradually, and U.S. economic growth persisted, albeit without the help of fiscal stimulus. Economic growth over the period was strong enough so that loan defaults not only remained low but also fell, to 1.39%, as of July 2017, according to J.P. Morgan, less than half their long-term 3.0% average. The J.P. Morgan Leveraged Loan Index provided a return of 6.51% over the 12 months ended July 31, 2017.  Such a return compares favorably to a 5.72% decline in the BoA Merrill Lynch 10-Year U.S. Treasury Index and a 1.60% gain for the BofA Merrill Lynch 1-3 Year U.S. Corporate Index for the same period.

Repricing Power
And yet, despite their relatively attractive performance over the past 12 months, bank loans have not provided what many investors were expecting: rising income. While LIBOR has increased, bank-loan yields actually have declined. For example, at the beginning of 2017, LIBOR was 1.00%, and most bank-loan rates were expected to adjust above their floor of LIBOR +1.00%, as the reference rate moved higher. Since then, LIBOR has moved to 1.31% (as of July 31). At the same time, however, the yield on the J.P. Morgan Leveraged Loan Index declined, from 6.23% to 5.84%, and spreads dropped, from 458 basis points (bps) to 416 basis points.

While some of the yield decline may reflect slightly higher prices on the underlying loans, the bulk of the reduction in yield and spread relates to repricing and refinancing of loans by borrowers. The increase in demand for bank loans from investors, combined with companies’ reduced need for taking out loans, empowered borrowers to refinance existing loans at lower yield and tighter spreads. Spreads over LIBOR have been negotiated lower and, in some cases, one-month LIBOR replaced three-month LIBOR as the base rate. J.P. Morgan reports that from the beginning of 2017 through July 31, 2017, repricing and refinancing activity represented 75% of bank-loan volume.

The rate-reducing effect of this refinancing has more than offset the rise in LIBOR since the beginning of the year, leaving investors with lower income than they expected. Can these repricings continue? Yes, but likely to a lesser extent. One constraint is that borrowers who refinance are generally restricted from refinancing again for six months. A more effective brake on spread narrowing may be the reluctance of lenders to agree to increasingly borrower-friendly terms. In other words, loans that were repriced 50–75 bps lower earlier this year may be able to capture only an additional 25 basis points in the next repricing.

Lenders’ willingness to accommodate borrowers seeking lower rates is not boundless. At some point, the limits of acceptable spread may be reached, and the ability to refinance at lower levels will end. It is difficult to say how soon this may happen. It may be less difficult to posit that the opportunities for most aggressive refinancing may be behind us.

Portfolio Relevance
The key factors that were seen enhancing performance expectations of bank loans—rising interest rates and improved economic growth—are both unfolding less rapidly than investors may have expected 12 months ago. Even more disruptive to the bank-loan investment concept has been the ability of many borrowers to reprice their loans at a narrower spread over LIBOR. Such repricings have offset the impact of rising LIBOR, but future repricing activity may be smaller and have less of a market impact; eventually, the quest for lower loan prices may reach the limit of investor tolerance. At that time, bank loans may provide the combination of income adjustment and price stability that investors expected in a rising-rate environment. (Note that while U.K. regulators recently announced plans to phase out LIBOR over the next few years, the bank-loan market likely will continue to rely on the benchmark for some time to come.)

In the interim, it’s worth noting that returns on bank loans have been relatively attractive over the last 12 months. In addition, current income levels, even though not as high as investors may have expected, have retained their appeal relative to other short-term alternatives. Furthermore, bank loans are still expected to perform well in a strong economy that enables the Fed to raise rates more aggressively—an environment likely to hurt the relative performance of other major types of fixed-income securities.

Indeed, if tax reform, reduced regulation on U.S. businesses, or improved global growth lead to a stronger U.S. economy, bank loans likely will continue to provide an effective fixed-income alternative. As a recent Market View pointed out, beyond the income component, bank loans offer other potential benefits for fixed-income investors, including historically low duration and effective portfolio diversification. (Note that no investing strategy, including diversification, can overcome all market volatility or guarantee future results.)  Even though refinancings may have adjusted income expectations lower, bank loans still may occupy an important role in investor portfolios.

 

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About The Author

RELATED FUND
The Lord Abbett Floating Rate mutual fund seeks to deliver a high level of current income by investing primarily in a variety of below investment grade loans.

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