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Fixed-Income Insights

We believe that with attractive valuations and solid credit fundamentals, leveraged loans deserve consideration as investors look at where they wish to allocate capital in 2015.

Leveraged loans have been a relatively unloved asset class of late. Net fund flows from retail investors have been negative for the last 11 months, with almost $36 billion exiting the loan market, according to Lipper. In spite of the outflows, corporate credit fundamentals have been favorable, as the slowly improving U.S. economy has contributed to strong corporate earnings. This has allowed issuers to improve their balance sheets gradually over the course of the past year. The asset class also benefited from relatively low exposure to the beleaguered energy sector. By contrast, the plunge in oil prices took a heavy toll on the high-yield bond market. Owing in part to a 15% weighting to the energy sector, the BofA Merrill Lynch U.S. High Yield Constrained Index was down almost 3% in the second half of 2014.

While the fundamental picture for the loan market has been modestly favorable, the technical health of the market has been inconsistent. A robust bid for leveraged loans from issuers of collateralized loan obligations (CLOs)—over $131 billion in 2014, according to J.P. Morgan—has been offset by a steady stream of outflows from retail investors. Interest-rate jitters undoubtedly were a factor. It seemed as if each time Federal Reserve (Fed) policymakers spoke of “patience” regarding the timing of the first increase in the fed funds rate, another $1–2 billion of retail cash left the leveraged-loan market.  

As the confusion regarding the Fed’s exit strategy created uncertainty among investors, increased scrutiny from regulators has further clouded the technical picture. We now have the Fed and other regulators inserting themselves into the discussion regarding how much leverage is “too much” for a new deal in the loan market, while also creating new rules that may affect the pace of CLO issuance in 2015 and beyond.

In this article, we will share our views on the near-term outlook for the leveraged loan market and provide investors with guidance through the noise stemming from the constantly changing regulatory environment and its effect on the supply/demand balance in the market. We find that:

  • Leveraged-loan valuations are fairly attractive, with spreads currently above their long-term average. Current dollar prices also leave room for capital appreciation.
  • Regulations may improve market technicals, and likely lead to higher-quality issuance.
  • As the Fed approaches “liftoff,” concerns about rising rates and attractive valuations should draw investors back into the asset class.

Leveraged Loan Valuations: Above Average
Owing to a strong appetite for risk assets in early 2015, the spread on the Credit Suisse Leveraged Loan Index versus LIBOR [London Interbank Offered Rate] has tightened by 46 basis points (bps) year to date through February 27, to 512 bps. (See Chart 1.) Despite the recent rally, leveraged-loan valuations remain attractive relative to their long-term average, with the current spread approximately 55 bps above its 23-year average. In addition to the attractive spread premium, there also is room for capital appreciation, with the average dollar price on the index near $97. Even higher quality loans are trading at a modest discount to par.

 

Chart 1. Loan Spreads Are Currently Wider Than the Long-Term Average
Credit Suisse Leveraged Loan Index versus LIBOR [London Interbank Offered Rate]



Source: Credit Suisse. The historical data are for illustrative purposes only, do not represent any Lord Abbett product or any particular investment, and are not intended to predict or depict future results.

 

For investors who focus on the relationship between leveraged loans and high-yield bonds, loans also look appealing relative to history. Following the recent recovery in the high-yield market, the yield premium that investors receive for investing in high-yield bonds (as represented by the Credit Suisse High Yield Index) recently stood at 60 bps, well inside the long-term average of 126 bps. (See Chart 2.) If the high-yield market continues to outperform leveraged loans, the relative value of the loan market should become even more compelling.

 

Chart 2. Loans’ Relative Value Versus High Yield Has Become More Attractive

Source: Credit Suisse. The historical data are for illustrative purposes only, do not represent any Lord Abbett product 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. An investor may not experience similar results.

 

The Technical Picture: The Good, The Bad, and The Downright Confusing
Both the supply and the demand equations for leveraged loans are influenced by the actions of the Fed and other regulators. While we are not advocates for increased regulatory interference, the upshot may be a better supply/demand balance in the market, and higher-quality issuance in the future. Here are our thoughts on the key issues that should affect the technical picture for the leveraged-loan market over the next several months.

CLOs—Despite regulatory uncertainty, the CLO market managed to price $132 billion in new deals in 2014, almost $45 billion ahead of 2013’s pace. And it also looks like 2015 is off to a strong start. However, the longer-term outlook for issuance is clouded by regulations related to the so-called Volcker rule and “risk-retention” rules as mandated by section 941 of the Dodd-Frank Act.* At the risk of oversimplification, CLO regulations stemming from the Volcker rule affect the types of CLO structures that banks can hold on their balance sheets. While the Fed has given banks until July 2017 to comply with these rules, most new CLO transactions being issued are coming to market “Volcker-compliant” from the start. The greater challenge is in the risk-retention rules connected with Dodd-Frank regulation. In short, issuers of new CLO transactions are required to retain 5% of the risk in these deals (i.e., “have some skin in the game”). While larger CLO managers have the scale to be able to issue in compliance with these rules, smaller CLO managers may get squeezed out of the market. Large CLO managers may be facing some additional headwinds, however. We are hearing that structured credit investors are hitting concentration limits on the amount of exposure they can have to these frequent CLO issuers. Unless a new universe of buyers emerges, we would expect that these large, well-established managers will find it more challenging to place CLO deals than they have in the past. Despite the robust pace of issuance last year—and the quick start we are seeing in 2015—we do expect volumes to be lower this year.

The impact of Fed lending standards on issuance—In March 2013, the Fed, the Office of the Comptroller of the Currency, and the Financial Crisis Inquiry Commission (FCIC) issued “supervisory guidance” on leveraged lending. The stated goal was to “ensure that federally regulated financial institutions conduct leveraged-lending activities in a safe and sound manner.” In layman’s terms, this means “don’t bring large, highly levered LBO deals to market.” Initially, banks did not pay much heed to the guidance, but gradually have taken greater notice as regulators have turned up the volume and also threated to use quality of loan issuance as a factor in stress-test evaluations. As a result, we have seen a decline in leveraged-loan issuance, despite a consistent bid for paper from CLO investors. (See Chart 3.)

 

Chart 3. Regulatory Environment Has Slowed Loan Issuance



Source: JP Morgan. The historical data are for illustrative purposes only, do not represent any Lord Abbett product or any particular investment, and are not intended to predict or depict future results.

 

Volumes slowed to a trickle at the end of 2014 and that has continued in 2015. For January and February 2015, total issuance was $27 billion, which is a fraction of the $114 billion that priced over the same period last year. Even if we strip out the impact of the re-pricings that occurred in early 2014, year-to-date loan issuance is running at 50% of last year’s pace.

The Fed and interest rates—At Lord Abbett, we aim to generate returns via sector and security selection, rather than trying to anticipate the direction of Treasury rates. This has served us well over the past few years, as many of our peers have found out how challenging it is to make interest-rate bets. However, despite the fact that it is a floating-rate asset class, the direction of rates can have a significant influence on retail flows into the leveraged loan market. As we have seen over the last several years, when the yield on the 10-year U.S. Treasury note goes up, so do leveraged-loan flows. (See Chart 4.)

 

Chart 4. Interest-Rate Changes Have Driven Loan-Fund Flows

Source: JP Morgan, Lipper, Bloomberg. "10 Year UST Yield" refers to the yield on the 10-year U.S. Treasury note.
The historical data are for illustrative purposes only, do not represent any Lord Abbett product or any particular investment, and are not intended to predict or depict future results.

 

The recent backup in rates has at least tempered the rate of outflows, and, consequently, has returned loan mutual funds back to breakeven.

What, then, could be the direction of rates from here? In our view, we believe that the Fed will initiate “liftoff” later this year with an initial hike in the fed funds rate. Given the presence of LIBOR floors in the loan market, coupons likely will not float higher for some time. However, as we mentioned earlier, with most leveraged loans trading at a discount to par, there is room for capital appreciation, as investors become attracted to the asset class due to fears of rising rates.

When we add this all up, we believe that the leveraged-loan market will be better off from a technical perspective over the next nine to 12 months. The CLO bid will not be going away, but it should diminish thanks to regulatory proposals that gradually are becoming the new rules of the road. Heightened scrutiny on new-issue quality should result in less issuance overall, with lower-quality transactions (the types we usually avoid) being displaced from the institutional loan market to the “shadow banking” system that has evolved since 2008. All told, these lower-quality issuers will still have access to capital, but not via the institutional loan market.  

The exact date of the first rate hike is very difficult to predict, but as the U.S. economy continues to slowly heal, we would not be surprised if flows into leveraged loans are positive, on net, in 2015.

Conclusion
It is hard to think of many asset classes across the globe that have not been affected by the evolution of the Fed’s monetary policy. However, the loan market is also being heavily influenced by its supervisory and regulatory functions. Thus, a firm understanding of these various cross-currents is key to making well-informed investment decisions within the asset class. While we are not particularly keen on the increasing amount of regulation being applied to the loan market, it may have one beneficial result: an improvement in the credit quality of loans issued over time.  

So where does this leave us? We believe that with attractive valuations, solid credit fundamentals, higher- quality issuance, and increasing investor concerns about rising interest rates, leveraged loans deserve consideration as investors look at where they wish to allocate capital in 2015. It may be time to give the leveraged-loan market some credit.

 

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