Exploring the Current Opportunity in Bank Loans | Lord Abbett
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Fixed-Income Insights

We believe the economic recovery and ensuing normalization in interest rates provide a supportive environment for bank loans.

Read time: 6 minutes

 

In Brief

  • Bank loans, also known as leveraged loans, historically have produced strong returns during periods of economic recovery, coincident with sharply rising U.S. Treasury yields.
  • The asset class provides a floating rate rather than fixed, which minimizes duration risk and provides an attractive coupon that resets when short-term rates eventually rise.
  • Bank loans may be a compelling way to maintain exposure to the macro recovery outside of equities, where volatility might be a concern.

 

Lower Relative Volatility and Diversification Benefits
The recovery in the bank loan market since April 2020 has been impressive. The sector not only rebounded from the credit dislocation caused by the COVID-19 crisis, but also produced positive, full-year returns by the end of 2020. The asset class proved to be resilient before, and through numerous market environments. Bank loans posted a positive annual return in 27 of the past 29 calendar years, based on the performance of the CS (Credit Suisse) Leveraged Loan Index.

In a broader sense, bank loans have also historically provided lower volatility and low correlation with other major asset classes, potentially making them an attractive diversification tool for fixed-income and equity portfolios (see Figure 1).

 

Figure 1. Bank Loans Have Historically Provided Lower Volatility and Low Correlation to Other Major Asset Classes
(Data as of 12/31/2020)

Source: Zephyr Style Advisor. Past performance is not a reliable indicator or guarantee of future results. CS = Credit Suisse. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Volatility is represented by standard deviation.

 

Competitive Returns in Rising-Rate Environments

More recently, bank loans have received notable attention, and for good reason. As the economic recovery came into view during the latter part of 2020, inflation concerns pushed U.S. Treasury yields markedly higher from the lows reached in early August, when the 10-Year U.S. Treasury Bond yield reached 0.51%. Since that time, the CS Leveraged Loan Index has returned 7.9% through the end of March 2021.

Historically, when inflation concerns mount, and long-term rates climb, investors look to bank loans because they offer an approach to minimizing duration risk in rising-rate environments (see Figure 2). Bank loans typically are floating-rate instruments with coupons that reference short-term benchmark rates, and as a result, they are largely insulated from moves in the longer-end of the yield curve.

 

Figure 2. Loans Have Historically Been a Buffer Against Rising Treasury Yields
Index returns during ten recent periods of greater than 100 basis point rise in the 10-Year U.S. Treasury Yield

Source: Morningstar. 1FTSE Russell 10-Year Treasury Bond Index, 2Bloomberg Barclays U.S. Aggregate Bond Index, 3Credit Suisse Leveraged Loan Index, 4ICE BofA High Yield Master II Index, 5S&P 500 Index

Past performance is not a reliable indicator or guarantee of future results. Performance during other time periods may have been different or negative. Other indexes may not have performed in the same manner under similar conditions. Returns longer than one year are annualized. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

As interest rates return to trend levels from extraordinary lows, we believe the normalization process in both rates and inflation will continue to provide a tailwind for the relative total return of bank loans. Leveraged issuers are positioned to realize enhanced benefits from recovering growth rates, the impetus behind current rising inflation expectations. Loans historically have served as a favorable way to play reflation (economic growth reverting and inflation rate returning to normal levels), particularly if you believe the market is underestimating the strength and timing of the U.S. economic rebound.

We should note that one unique aspect of the current cycle is that the Fed (Federal Reserve) is suggesting it will be quite patient in lifting its policy rate, even as growth and inflation expectations normalize. So, while a rise in short-end rates like Fed Funds and LIBOR (London interbank offered rate) have historically been a tailwind for bank loan returns in the form of coupons resetting higher, this cycle may see that tailwind come later than normal. But the ability to protect returns relative to assets with longer duration in a rising-yield environment remains a key allure of the bank loan market.

Expected Improvement in Leveraged Issuer Fundamentals

Bank loans weathered the pandemic-induced crisis better than many had expected, as loan borrowers were able to address short-term liquidity needs through an active new issue market, for the most part. Poorly operating or capitalized issuers in the energy, leisure and entertainment, and retail industries accounted for a majority of defaults, but overall, default rates remained below expectations and ended March at 3.34% (see Figure 3).

 

Figure 3. U.S. Leveraged Loan LTM Default Rates Turning Lower 
(Par weighted by volume)
(Data as of 3/31/2021)

Source: J.P. Morgan. In April 2014, the trailing 12-month default rate increased by 2.6% due to the default of Energy Futures Holdings (formerly known as TXU Energy). As of April 30, 2015, this default was no longer included in the 12-month rate. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Default rates in 2021 are running below pre-pandemic levels compared to the same period last year, according to Fitch Ratings1. Improving economic growth will provide an additional boost to leveraged issuers’ fundamentals, enabling the trailing twelve-month default rate to continue the turn lower through the year, in our view.

Recent Performance Comes Off Dislocated Valuations

Although the asset class has performed particularly well since August, when longer-duration U.S. Treasury yields started to rise, the loan market is coming off dislocated prices that have only recently reached levels typically seen during times of relative economic stability (see Figure 4).

 

Figure 4. Bank Loan Valuations: Periods of Price Stability Typically Follow Compression
Prices moved off dislocated lows but have yet to remain at previously sustained levels.
CS Leveraged Loan Index: Average Dollar Price by Rating
(Data as of 3/31/2021)

Source: CS Leveraged Loan Index data as of 3/31/2021. Past performance is not a reliable indicator or guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett 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.

 

Figure 4 points to two aspects of the leveraged loan market:

  1. It is perhaps not widely appreciated that a significant proportion of the loan market can trade at or above par for long periods of time, and
  2. Yield is the primary contributor to total return over most periods, allowing for relative price stability of the BB- and B-rated proportion of the loan market, outside of episodes of economic stress.

In normalized economic conditions, the BB-rated proportion of the loan index has typically traded at $99 or higher, and the B-rated proportion has traded at $95 or higher. We believe an extended period of relative price stability is warranted, given recovering growth prospects and the associated potential for an extended, normalized credit and economic cycle.

Market Dynamics Look Promising

The positive macro environment for bank loans is supplemented by demand dynamics that, we believe, bode well going forward. CLOs (Collateralized Loan Obligations) are by far the largest holder of bank loans, representing about 60% of bank loan ownership (see Figure 5). This is notable because as term-funded investors, CLOs can provide a stable holder base through periods of market instability. CLO formation has rebounded smartly since the market disruption in March 2020, and more recently, in February 2021, climbed to levels seen prior to the COVID-19 crisis, as shown in Figure 6.

 

Figure 5. The Majority of Bank Loans Are Held by CLOs
CLOs hold a majority of the bank loan market and represent a significant portion of loan demand.
Bank Loan Holdings by Investor Type ($bn)
(As of 2/28/2021)

Source: J.P. Morgan. Data as of 2/28/2021. A collateralized loan obligation (CLO) is a single security backed by a pool of loans, collected into a marketable instrument via process known as securitization. CLOs are often backed by corporate loans with low credit ratings or loans taken out by private equity firms to conduct leveraged buyouts. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett 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. Past performance is not a reliable indicator or guarantee of future results.

 

Figure 6. A Revival in CLO Formation Is a Strong Source of Bank Loan Demand
CLO formation has only recently reached the levels previously seen during positive environments for bank loans.
U.S. CLO Issuance ($MM)
(As of 2/28/2021)

Source: S&P Global Inc. LCD. Data as of 2/28/2021. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Past performance is not a reliable indicator or guarantee of future results.

 

Based on CLO activity during prior, favorable market environments, we believe CLO formation will remain robust amid an environment where investors are searching for normalization themes but wary of interest-rate exposure.

Net flows for bank loan funds and ETFs (exchange-traded funds) have followed a similar pattern to CLOs. Inflows have historically coincided with rising Treasury yields, and outflows occur when interest rates move lower, as shown in Figure 7. Importantly, substantial outflows have been persistent for nearly two years as rates declined to record lows. We believe the recent come-back in inflows this year will be followed by continued retail-investor interest as Treasury yields move higher, and the prospects for short-term interest rates to rise as a tailwind for coupon income become more likely.

 

Figure 7. Loan Fund Inflows Still Far Short of Previous Peaks
Recent inflows into bank loan funds remain significantly less than the $85 billion in outflows that characterized the asset class from Q4 2018 to Q4 2020.
U.S. Loan Fund Flows ($BN)
(As of 3/31/2021)

Source: Lipper and Bloomberg Index Services Limited. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Past performance is not a reliable indicator or guarantee of future results.

 

Final Thoughts and Considerations

Bank loans have historically provided lower volatility than equity and high-yield bonds and can complement most fixed-income and equity portfolios. The normalization in the macroeconomic environment provides a positive backdrop for leveraged loans, in our view, and we believe a recovery in both demand as well as leveraged issuer fundamentals will be supportive.

The sector proved resilient during major market impacts, such as the recent crisis, but there are caveats to consider. Leveraged loans are primarily below investment-grade instruments and the credit quality profile of the loan market, based on the CS Leveraged Loan Index, is dominated by B-rated issuers. Bank loans typically are first lien, senior secured debt, which has a higher priority claim on assets in the event of default over bonds or equity. However, the proportion of the loan market that is from loan-only issuers has been growing. And finally, there is the liquidity consideration. Leveraged loans are often less-liquid securities than corporate bonds and require significant research, portfolio management, and operational resources dedicated to the sector.

We believe Lord Abbett’s experienced investment team in the leveraged loan space is well positioned to provide a thorough and consistent approach to harvest potential gains, while being keenly mindful of the potential risks.

 

1 Fitch Ratings, Fitch U.S. Leveraged Loan Default Insight (YTD Defaults Down Versus 2020; Loans of Concern Total Drop Continues), February 19, 2021.

 

A Note about Risk: 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 interest rates rise, the prices of debt securities tend to fall. High yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Lower-rated bonds carry greater risks than higher-rated bonds. The principal risks associated with bank loans are credit quality, market liquidity, default risk, and price volatility. While bank loans are secured by collateral and considered senior in the capital structure, the issuing companies are often rated below investment grade and may carry higher risk of default. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer maturity of a security, the greater the effect a change in interest rates is likely to have on its price. No investing strategy can overcome all market volatility or guarantee future results.

Neither diversification nor asset allocation can guarantee a profit or protect against loss in declining markets.

There is no guarantee that the floating-rate loan market will perform in a similar manner under similar conditions in the future.

The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize, or that actual returns or results will not be materially different from those described above.

Any examples provided are for informational purposes only and are not intended to be reflective of actual results.

A basis point is one one-hundredth of a percentage point.

Exchange Traded Fund (ETF) is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold.

The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated, leveraged-loan market.

The ICE BofA High Yield Index tracks the performance of U.S. dollar denominated, below-investment- grade, corporate debt publicly issued in the U.S. domestic market.

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.

ICE BofA Index Information:

Source: ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofA INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofA INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD, ABBETT & CO. LLC., OR ANY OF ITS PRODUCTS OR SERVICES.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action, as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product, or service may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research, or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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