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Fixed-Income Insights

Jeffrey D. Lapin, Lord Abbett Portfolio Manager of the Bank Loan strategy, explains that paying close attention to yield relationships among industry peers enables his team to optimize a portfolio of bank loans.

Bank loans, also known as leveraged loans, senior secured loans, or floating-rate loans, typically pay an interest rate that is tied to the London Interbank Offered Rate (LIBOR), a rate that banks charge each other for short-term loans. As LIBOR moves, rates on bank loans are adjusted periodically, usually every 30–90 days.

The borrowing company typically has a credit rating that is below investment grade, and, therefore, the yield on a bank loan can be more attractive than on other instruments. The low credit ratings suggest that bank loans are comparable to high-yield bonds, but unlike those bonds, bank loans are commonly secured by the borrower's assets. This gives these loans seniority in the borrower's capital structure, putting loan holders ahead of other capital providers in the event the borrower declares bankruptcy. In these circumstances, holders of bank loans are more likely than holders of equity and unsecured bonds to recover all or part of their investment.

Although bank loans typically have five- to seven-year terms, the borrower may call the loan at any time and repay it completely or in part. This means that loans are unlikely to trade above par value,1 placing a cap on the investment's upside potential. Jeffrey D. Lapin, Portfolio Manager of  Lord Abbett's Bank Loan Strategy, discusses the strategy. 

Q. How do you approach the bank loan market?
A: Bank loans are very credit-specific. That is, the value of a loan reflects not only a particular company and its outlook but also its industry as well as the company's capital structure. So, we definitely approach the market from a bottom-up perspective.

But we also develop a view on where we would like to position the portfolio, given our view of the economy and the market. If, for example, we have a negative outlook for the metals industry, then we're unlikely to invest in that industry unless the loan is unusually attractive.

On the other hand, our view of a particular sector is also informed by our analysts' views. So, for example, currently we have a negative view on the healthcare industry due to the risk that Medicare reimbursement rates could be affected by healthcare reform. But not all segments of the industry are equally affected by that risk, according to our analysts. So, although we underweighted health care overall, the portfolio is overweight in certain segments that we believe face less of that risk.

We also develop an overall outlook for the loan market. This is often based on our monitoring of the supply and demand factors. At the end of last year, for example, we spoke with major investment banks to get a sense of the supply of loans that would be coming to the market and of how much demand there would be, especially from collateralized loan obligations.2 Based on this, we believed there would be strong demand and insufficient supply, which would have the likely effect of driving the market higher.

As for credit quality, we will position the portfolio where we believe the market is offering the most value. Early in 2013, we anticipated that loans in the midrange of quality were offering the best opportunities, so we positioned the portfolio there initially. When the spreads on those loans tightened versus Treasuries, we swapped out of those and into higher-quality loans and into high-yield bonds and second-lien loans,3 which are considered lower quality. The rationale for this "barbell strategy" was that, in many cases, the higher-quality loans had repriced at a lower coupon rate,4 freeing up cash flow for payment on the company's high-yield bonds and second-lien loans, reducing the risk of those instruments.

Q. How important are duration and maturity?
A: Theoretically, loans don’t have a duration because they have a floating-rate coupon. But we do pay attention to a loan's maturity.5 It's not the most important factor in our decision, but we try to make sure that we're paid a little more for investing in loans with longer maturities.

Duration is more important in the bond portion of our holdings, which accounts for only about 7% of the portfolio [as of July 19, 2013]. We try to keep maturities to eight years or less, and we try to keep effective duration6 relatively short. We have the ability to further hedge interest-rate risk by utilizing Treasury futures.

We invest in bonds as a way to access sectors that are underrepresented in the loan market. There are relatively few energy sector loans in the market, for example, so we own some high-yield bonds in that industry.

We also view bonds as a way to add alpha7 versus our benchmark. We're not benchmarked to bonds, so if we buy a bond, it's because we believe the total return opportunity is very good.

Q. How do you approach valuation?
A: Most of the loans we hold are from companies that are asset-heavy. They have a lot of real estate, factories, equipment, and the like, so we pay attention to the value of those assets since they are backing the loans we own. We also look at loan-to-value coverage, taking into account the total enterprise value of the business.

We also monitor pricing multiples in the equity market and in merger and acquisition [M&A] deals. This gives us another perspective on the value of a company's assets. And we can learn something about a company's value by consulting with our equity analysts. For example, if we own a loan issued as part of a leveraged buyout,8 we would seek the insights of the analyst who followed the company while it was still publicly held.

With regard to yield, we monitor that constantly. We're always comparing yields on comparable instruments, especially within an industry. This enables us to swap out of relatively expensive loans and into those that are relatively cheap. A number of insurance brokers came to market in 2012, and our analyst followed them closely, noting how they traded relative to each other. That gave us an idea of how much yield we needed in order to hold one versus another. This, in turn, enabled us to swap one for another when the yield spreads were right.

We do this type of trading in a number of different industries. In other words, we don't just sit on our positions. We view the portfolio as dynamic, and we look to optimize it every day. In a field where a few basis points9 can make a big difference, being able to do swaps like this can make a huge difference in performance. This differentiates us from our peers.

Q. What about your sell discipline?
A: We do that in a number of ways. When an analyst recommends an issue, we'll discuss its relative value and the range we believe it should trade in. We also pay attention to credit risk concerns. So, if our investment thesis for a company depends on X, and the latest earnings report calls X into question, we would consider selling.

We might also change our view of what is happening in the economy, which could affect the attractiveness of an industry. That could lead us to trim our positions in that industry. And as I mentioned earlier, we watch yield relationships among credits and will trade and swap on that basis as well. We're pretty active in that regard.

Q. How do you approach risk management?
A: The risk in bank loans is asymmetric. That is, the upside is capped because most loans are callable at par. So it is the downside that needs to be managed, and we manage that in a couple of ways. First, we maintain a reasonable number of positions, about 300–400, which limits our exposure to the risk inherent in each one. Second, our analysts follow the companies quite closely, so we stay on top of any risks that might arise from individual holdings.

And third, we maintain a "watch list," which is a list of our riskier holdings. These are holdings that are higher yielding, which indicates the market perceives them as riskier. The borrower could be a leveraged buyout with higher-than-normal leverage, for example. We might decide to buy a loan like this because we think the borrower is likely to exceed expectations in paying down its debt. But this kind of an investment would merit closer-than-normal attention. We watch everything attentively, but we watch investments like these even more closely.

Q. Bank loans are considered an inflation hedge. Does this asset class have any appeal in other investment environments?
A: Bank loans have a number of features that are attractive regardless of the investment environment. They historically have tended to be less volatile than fixed-income investments, for example. And because they are secured by the borrower's assets, they historically have offered greater security in the event of bankruptcy. In addition, they tend to have attractive current yields. Of course, there is no guarantee floating-rate loans will perform in a similar manner in the future.

In fact, in a low-rate environment, bank loans should be viewed as a yield instrument. But unlike other yield instruments, bank loans offer some protection in the event that rates rise. Normally, when that happens, the value of a fixed-income security will fall. But with a bank loan, the coupon rate adjusts upward when LIBOR rises, so that provides some protection.

But with the Federal Reserve and other central banks committed to keeping short-term interest rates from rising, LIBOR could stay low for a while. So, the coupon on a bank loan won't adjust immediately even if interest rates on the long end of the yield curve are rising. This failure to adjust immediately helps to explain why, in the current environment, the protection against rising rates may not be perfect.

When the yield on Treasuries moves up dramatically, it is possible that bank loans could see their yields rise. Hypothetically, it's unlikely that the yield on a bank loan would remain at 4.5%, for example, when Treasury yields go up by 50 or 60 basis points.

On the other hand, bank-loan prices should not fall as much as fixed-coupon bond prices or remain as low in the long run when Treasury yields rise. Bank loan prices may drop in the short term when Treasury yields climb, but when rates at the short end of the curve begin to increase, then bank loans, with their floating-coupon rate, may provide protection in a way that fixed-coupon securities will not.


1 Par value, also known as face value, is the amount repaid to the investor when the bond matures. A bond may trade above, below, or at par value, depending on current interest rates.
2 Collateralized loan obligations are securities backed by a pool of business loans. These are issued in various tranches with different interest rates and levels of risk.
3 Second-lien loans are loans that are secured by the borrower's assets but that have less seniority than other forms of secured debt. That is, in the event of a borrower's bankruptcy, the holder of a second-lien loan has a right to the borrower's assets only after holders of more senior debt.
4 Coupon rate is the interest rate on a bond, expressed as a percentage of the bond's par value.
5 Maturity is the length of time a borrower is given to repay the loan. A loan with a maturity of five years must be paid back within five years.
6 Duration is a measure of the sensitivity of a bond's price to a 100 basis-point change in interest rates. Because this sensitivity is affected by the length of the period over which interest and principal payments are made, calculating the duration on bonds that have embedded options is different. Effective duration takes embedded options into account. If a loan has a call option, for example, that is, if the borrower may repay the loan before it matures, then effective duration makes an adjustment for this. If interest rates were 6%, and the interest rate on a loan were 10%, a borrower might choose to repay the loan in order to obtain the lower rate. Repayment of the loan would shorten the period over which the loan's coupon and principal are paid. Effective duration adjusts for this shortened payment period, while the standard duration calculation does not. Effective duration, therefore, is a better measure for loans and bonds with embedded options.
7 Alpha is a measure of investment performance. It is an indication of how much an investment manager outperforms a benchmark index on a risk-adjusted basis. In other words, how much return did the manager generate in excess of what was expected, given the amount of risk taken.
8 A leveraged buyout is the acquisition of a company using a large amount of debt, often secured by the assets of the acquired company.
9 A basis point is 1/100 of a percentage point.


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