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Fixed-Income Insights

Most investors focus exclusively on the asset class' performance in a rising rate environment, but they could also consider its attractive long-term risk-adjusted returns.

As we get closer to an interest-rate “liftoff” from the U.S. Federal Reserve (Fed), it is likely we will start to see a slew of research reports and news articles making the case for leveraged loans in a rising-rate environment. However, these reports will miss a crucial point: Investing in leveraged loans simply as an interest-rate play understates both the risks and the significant long-term benefits of the asset class.

While loans are floating-rate assets, the ultimate obligors are high-yield companies, which are rated as such for a reason. The credit risk inherent in these companies provides the asset class with a very attractive income stream. These loans sit at the top of high-yield companies’ capital structures, are secured by assets, and feature covenants that may offer loan holders some measure of protection. As a result, losses from defaults historically are lower than we see in high-yield bonds. Therefore, investors keep the majority of that attractive coupon over time.

Back in a March 2015 commentary, we discussed our favorable outlook on the loan market due to attractive valuations, and very strong supply/demand technical factors. Since that time, much of our thesis has played out with year-to-date (through Oct. 31) leveraged loan volume down 33% versus 2014 at $293 billion, and CLO issuance on track to hit over $100 billion again this year, according to JP Morgan. These factors have aided performance in a choppy year for corporate credit. At the end of October, the year-to-date return on the Credit Suisse Leveraged Loan Index was 1.48%, well ahead of the 0.29% return on the Merrill Lynch U.S. High Yield Constrained Index. In addition to a strong technical picture, loan performance relative to high yield has definitely benefitted from the asset class’s much lower exposure to the slumping energy sector (which represented 4% of issuance for loans versus 13% for high-yield bonds).

As we approach year-end, investors find themselves in a conundrum. For many, the need for income remains, but is offset by concerns about global growth, the Fed’s policy direction, the level of longer-term interest rates, and a credit cycle that is fairly long in the tooth. For advisors and clients who find themselves in this predicament, we would suggest that they take a fresh look at the leveraged loan market. It has been a consistent source of income and attractive risk-adjusted returns for over 30 years. In fact, since 1992, leveraged loans have only posted one year of negative returns. Of course, that year was 2008, a disastrous time for most asset classes. We can attribute loans’ resiliency to what some would call the power of the coupon—the cushioning effect of a high income stream on total return—and, potentially, a relatively high safety net in the event of default.

The “safety net” potential is especially important. If we look back over the last 20 years, the average recovery rate (the amount that creditors “recover” from defaulted loans) on first lien loans is just under 70% of par and the default rate is 2.75%, according to Credit Suisse. When we combine these two data points we get the “loss rate,” which is something long-term investors should focus on. In other words, if I invest $100 in the loan market today, what will be my losses from defaults over the following year? Here, the long-term average annual loss rate in the loan market is only 1.32%, with a high of 5.44% in the default-plagued year of 2009.

Chart 1 examines annual credit loss rates relative to the spread above LIBOR that an investor in leveraged loans would have received if they had invested in the leveraged loan index at the start of the year. As you can see, the power of the coupon often wins out over credit losses. For all years, credit losses ate into only a portion of the spread premium that investors would have captured in the asset class at the start of the year. Of course, this analysis does not account for mark-to-market risk, which was significant back in 2008. That was a period when many leveraged credit investors overextended themselves in the loan market and were ultimately forced to liquidate their positions into a weak market. However, it does highlight the attractive compensation that investors receive relative to actual credit losses in the asset class. The stable income stream and low interest-rate sensitivity have led to very attractive risk-adjusted returns for the leveraged loan market. One could argue that a portion of the excess spread constitutes a “liquidity premium,” a concept we will discuss later.

 

Chart 1. Loans’ Spreads Have Cushioned Leveraged Loan Investors from Defaults
Annual loss rates and starting spreads on leveraged loans, 1998-2014

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

 

Boosting Fixed-Income Returns and Lowering Volatility
With spreads in the loan market* currently just over 600 basis points (bps), which is roughly 120 bps above their long term average, there is a solid case to be made for the attractive valuation of this asset class. In addition, the discounted average dollar price of $94 in the loan market provides investors with the opportunity for capital appreciation, in addition to current income. While few investors would wish to have their full fixed-income allocation in leverage loans, it is possible to create a portfolio that generates very strong risk-adjusted returns by blending leveraged loans with other fixed- income asset classes.

Table 1 spotlights one such combination, a blend of 70% core bonds (as represented by the Barclays U.S. Aggregate Bond Index, or Barclays Aggregate) and 30% leveraged loans (as represented by the Credit Suisse Leveraged Loan Index), compared with both the Barclays Aggregate and the loan index by themselves, as well as a representative high-yield bond index. The chart covers performance over the past five- and 10-year periods (the latter including the credit crisis of 2008). Over the past five years, it would clearly have been better to be 100% invested in leveraged loans, but the 70/30 blend did provide much more attractive risk-adjusted returns. Over the last 10 years, the 70/30 blend provided superior risk-adjusted and absolute returns relative to the Barclays Aggregate or the Credit Suisse Leveraged Loan Index.

The blend also compares well in another important category. Over the last 10 years, the blended strategy saw only five quarters (13% of the time) of negative total return, with the largest drawdown of -3.67% in the rather painful fourth quarter of 2008. We think this statistic is important. Investors often look to their fixed-income allocations to act as a “shock absorber” when equity markets become volatile. This strategy has provided that, as well as a respectable annual return. The current yield on this strategy as of November 20, 2015, was approximately 3.80%, not a bad option in a yield-starved world.

 

Table 1. A Leveraged Loan-Core Bond Combination Has Offered Attractive Risk-Adjusted Returns
Total return, standard deviation, and Sharpe ratio for indicated asset categories

Source: Barclays, Credit Suisse, BofA Merrill Lynch, Lord Abbett. Leveraged loans represented by Credit Suisse Leveraged Loan Index. High yield bonds represented by BofA Merrill Lynch U.S. High Yield Constrained Index. The historical data are for illustrative purposes only, do not represent 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. An investor may not experience similar results.

What about Liquidity in the Loan Market?
Liquidity is an issue that is on the top of the minds of all fixed-income investors, but especially those who are considering an allocation to the leveraged-credit markets. However, it is important to remember that even prior to the 2008-09 credit crisis, loans were never an asset class that would be considered very liquid. In addition, many reports on the status of liquidity in the corporate bond markets in general have either been ill-informed or downright misleading. While liquidity is tougher to come by in the post-crisis world, the fact is that the market has weathered over $37 billion in mutual fund outflows over the last two years. It is also important to consider that retail investors are just a portion of the leveraged-loan market. Over 80% of leveraged loans are held by collateralized loan obligation vehicles (CLOs) and other institutional investment strategies. Institutional investors tend to be much more stable investors, and are not as demanding of daily liquidity as retail investors. When we consider the significant spread premium that investors realize relative to loss rates, one could argue that investors are fairly compensated for the less liquid nature of the loan market.

 

Chart 2. Mutual Funds Account for Less Than 20% of the $800 Billion Loan Market
Share of the U.S. bank loan market by ownership category, as of December 31, 2014 (latest available)

Source: J.P. Morgan. CLOs refer to the collateralized loan obligation market.

 

Conclusion
As 2015 comes to a close, we will have seen our seventh year of “ZIRP” (zero interest rate policy) in the United States, and markets remain starved for attractive sources of income. Even if the Fed does modestly increase the fed funds rate in December, we expect policymakers to move at a gradual pace with most other central banks around the world continuing to have an easing bias. We are also having more discussions with investors abroad who are seeking yield in the U.S. leveraged-credit markets. When we look at the solid risk-adjusted returns that loans have provided for nearly a quarter-century, a strong case can be made for investors to have at least a portion of their fixed-income allocation invested in the asset class. Admittedly, the leveraged-loan market is more complex and less liquid than other sectors of fixed income. Fortunately, we at Lord Abbett have over 40 years of experience investing in the leveraged-credit markets, and have designed a process that historically has delivered strong risk-adjusted returns for our clients.

*As represented by the Credit Suisse Leveraged Loan Index.

 

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