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Fixed-Income Insights

The second part of our series on implications of possible interest-rate increases by the U.S. Federal Reserve (Fed) examines the potential impact on the U.S. leveraged-loan market. 

 

In Brief

  • The primary focus of the U.S. bank loan market remains the prospect of an interest-rate hike by the U.S. Federal Reserve in 2015. Investor concerns have resulted in outflows from the bank-loan sector and have produced lower prices and higher yields over the past year.
  • To anticipate the potential Fed impact in 2015, it may be helpful to examine how the sector has performed during previous rate-hike cycles. [Of course, past performance is no guarantee of future results.]
  • In each of the last three intervals of Fed rate hikes since 1994, the representative Credit Suisse Leveraged Loan Index outperformed the Barclays U.S. Aggregate Bond Index (which is a broad barometer of the U.S. fixed-income market) and the two-year U.S. Treasury note. 
  • The key takeaway—Based on current valuation measures, the bank loan sector offers potentially attractive relative returns almost regardless of when the Fed chooses to hike rates. 

 

With negative yields on the two-year sovereign debt of Germany and Japan, and the two-year U.S. Treasury yielding less than 0.65%, the yield on U.S. bank loans (as measured by the Credit Suisse Leveraged Loan Index) looks suspiciously attractive at 5.6%, as of January 31, 2015. This compares to a yield on the index of 4.98% at the beginning of 2014 (according to data from Bloomberg and Credit Suisse).

Indeed, the increase in yield on bank loans during the past year is somewhat surprising, given the decline in rates on sovereign debt of developed countries and expectations that default rates on bank loans will remain below historical averages. But it makes more sense if you consider that the yields on bank loans often move in tandem with those of U.S. high-yield securities. 

The key factor here was a fresh bout of “risk off” behavior by investors. Yields rose on traditional U.S. high-yield debt, leading to significant outflows in the asset class. Similarly, yields on bank loans also rose, as outflows from U.S. bank-loan mutual funds exceeded $24 billion during the last nine months of 2014, based on Lipper data. The flight from risk was widely attributed to concerns about the negative consequences of lower priced oil, slower global growth, and the impact of dollar strength on the exports and profitability of U.S. companies.

While those factors certainly have influenced investor behavior in recent months, there is one overarching concern that is dominating the leveraged-loan market’s attention: the prospect in 2015 of an interest-rate hike by the U.S. Federal Reserve. As part of a series examining “the Fed factor” and its potential impact on various asset classes in 2015, we’ll take a closer look at the bank-loan market—and how it might respond to policy changes from the U.S. central bank.

Misplaced Concerns
First, though, let’s return to the list of worries referenced earlier. The fears driving the risk-off behavior may be less justified in the bank-loan sector than in the high-yield market or even the U.S. equity market (as represented by the S&P 500). With regard to an adverse impact of lower oil prices on energy-related credits, the energy sector accounts for only 4% of the Credit Suisse Leverage Loan Index, compared to 13% of the J.P. Morgan High Yield Index. The index weighting of harder-hit segments of the sector, such as oil field services and exploration and production, is smaller still. 

Slower global growth is another investor concern that has already affected foreign earnings of larger international companies. However, the traditional domestic orientation of companies issuing leveraged loans offers some insulation from effects of economic and currency weakness outside the United States. 

The strength of the U.S. dollar also can reduce the profitability of international companies as exports become less competitive and non-U.S. sales decline. But again, the domestic nature of most companies in the Leveraged Loan Index reduces the concern that a stronger U.S. dollar will meaningfully affect their profitability.   

U.S. Economy and Fed Policy
So if the issuers within the bank-loan index are less influenced by global growth and currency factors, and more dependent on domestic considerations, U.S. gross domestic product (GDP) growth and policy moves by the Fed are likely to be important factors in the performance of this asset class in 2015 and 2016. While GDP numbers have not been remarkable over the past few years, persistent growth of 2.0–2.5% has been supportive of credits in the bank-loan index, and has kept bankruptcies below historical averages. Recent improvement in employment and wages, complemented by lower fuel costs and cheaper imports, suggest that 2015 economic growth holds potential for further improvement. Accordingly, JP Morgan expects high-yield default rates to be about 2.0% for both 2015 and 2016, below historical levels of 3.5%.1

Employment and earnings growth that support economic growth also are key focal points for Fed policy. The January 2015 employment report from the Bureau of Labor Statistics revealed that 1.0 million jobs were created over the three-month period ended January 2015. At the same time, year-over-year wage growth increased, from 1.7% in December 2014 to 2.2% in January. While 2.2% is barely above the Fed’s inflation target of 2.0%, more robust employment levels imply that wage growth above 2.0% is not only sustainable but also it could accelerate. According to Empirical Research Partners, the number of unemployed persons per job opening has declined, to 1.6 to 1, compared to more than 5 to 1 in 2009. Research by UBS economists suggests that a ratio of 2.0 to 1 unemployed persons per job opening is the threshold below which compensation increases as employers compete for talent. A continuation of recent job growth, especially if accompanied by raising wages, will support an initial Fed rate hike as early as June 2015. 

Recent commentary by members of the Fed’s policy-setting arm, the Federal Open Market Committee (FOMC), suggests some are already thinking along this time frame. Remarks in late January and early February by the presidents of the Federal Reserve banks of Philadelphia, Cleveland, Richmond, Atlanta, St. Louis, and San Francisco all imply or specifically reference June as an appropriate date to raise rates. With a prospective initial rate hike that near in time, an examination of the performance of bank loans during previous periods when the Fed raised interest rates can be illuminating.

Bank Loans and Historical Rate Hikes
There have been three Fed-tightening cycles since the beginning of reliable bank-loan index data in 1992. In each of those periods, bank loans (as measured by the Credit Suisse Leveraged Loan Index) outperformed both the Barclays U.S. Aggregate Index and a more defensive alternative, a two-year U.S. Treasury index. As Table 1 demonstrates, the three Fed-tightening periods that began in 1994, 2000, and 2004 represent a range of rate hikes and time frames.

 

Table 1. Bank Loans Have Performed Well, on Average, During Previous Fed Tightening Cycles
Total return by index during indicated periods of Federal Reserve rate hikes

Source: Federal Reserve Bank of New York, Barclays, Citigroup, Credit Suisse. Two-Year U.S. Treasury = Citi Treasury Benchmark 2-Year Index. Barclays Aggregate = Barclays U.S. Aggregate Bond Index. CS Leveraged Loan Index = Credit Suisse Leveraged Loan Index. Historical data for Credit Suisse Leveraged Loan Index is monthly; returns reflect nearest month-end.
Past performance is no guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Due to market volatility, the market may not perform in a similar manner in the future.
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. 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.

 

In each case, the bank loans performed well relative to the alternatives. The three-cycle average performance of 6.04% for the leveraged loan index compares favorably to 2.41% and 1.02%, respectively for the two-year U.S. Treasury index and the Barclays U.S. Aggregate Bond Index. While past performance is no guarantee that bank loans will again perform in a similar manner in the next rate-hike cycle, the fact that the Fed insists policy decisions will be “data dependent” suggests initial rate hikes will coincide with evidence of self-sustaining U.S. economic strength. More robust U.S. growth likely would also support the economically sensitive bank loan sector.

Consequences of a Delayed Hike
But what if the Fed decides not to raise rates in June, or even September, but delays action until December or March 2016? The expected return of bank loans in this scenario of a delayed rate hike will depend on the underlying economy. If the U.S. economy continues to grow at a rate of at 2.0–2.5%, and the Fed postpones higher rates, bank loans should perform quite well. In this scenario, the higher relative yield of bank loans will have more time to compound, providing the basis for relatively attractive returns during the “waiting period.”

The scenario that likely would compromise the performance of bank loans is an economic slowdown. U.S. GDP growth of less than 2.0% could create concerns that defaults could increase, leading to another round of “risk off” behavior by investors and accompanying outflows from bank-loan mutual funds. While this scenario does not seem imminent, given recent improvement in U.S. employment, continued, solid levels of consumption, and the anticipated economic benefits of lower-priced oil and cheaper imports, it is prudent to understand potential downside risks—and how likely they may be to occur.

Investment Implications
Investor concerns have resulted in outflows from the bank-loan sector and have produced lower prices and higher yields over the past year, even as yields of short-term, high-quality debt have dropped. The widening differential in yields, and the relative value it signals for bank loans, belies the low default levels expected for the sector. Barring an economic slowdown, leveraged loans offer potentially attractive relative returns almost regardless of when the Fed chooses to hike rates.

 

1”Credit Strategy Weekly Update,” J.P. Morgan North American High Yield and Leveraged Loan Research, February 13, 2015.

 

What Happens When The Fed Finally Hikes Rates?

How might various investments react after the Federal Reserve starts raising interest rates? In this series, Zane Brown looks at the potential impact on:

▪ High Yield
▪ Bank Loans
▪ Short Duration
▪ Equities

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