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Fixed-Income Insights

The factors that pressured rates lower appear to be easing. Meanwhile, U.S. bank-loan portfolios still offer attractive income and low volatility.

Mutual funds that invest in bank loans (also referred to as floating-rate funds) appear, in our view, to offer an ideal combination of low volatility and relatively attractive income that potentially can adjust higher whenever the U.S. Federal Reserve (Fed) hikes interest rates.  

Investors seeking such a combination of characteristics persistently poured money into U.S. bank-loan funds from early August 2016 through the end of March 2017.  Reuters reports that during this period, every week but one saw positive inflows. According to Thompson Reuters Lipper, total inflows during this eight-month period reached nearly $22.5 billion.

Many of these investors were encouraged by an increase in the three-month London interbank offered rate (LIBOR), the rate upon which most loan rates (worldwide) are based. As a result of financing pressures created by U.S. money-market reform measures implemented in October 2016 (such as requiring prime institutional money market funds to “float their NAV” by December 2016) LIBOR increased to 1.00%, the LIBOR floor beyond which subsequently higher rates should push bank-loan rates higher. 

Rising Demand, Reduced Supply
By year-end 2016, then, investors expected that future Fed rate hikes would be reflected in bank-loan rates that would adjust higher.  Accordingly, investors increased allocations to bank-loan funds.  In the first quarter of 2017 alone, loan funds reported inflows of nearly $14 billion.  This compares with outflows of $5.6 billion for the same period in 2016.

As investor flows began to build, a shift in bank-loan generation started to unfold in late 2016.  After the U.S. presidential election in November, bank lending related to mergers and acquisitions declined, as deals were delayed pending further clarification of tax and regulatory policies.  The resulting supply/demand imbalance empowered existing borrowers to reprice (change the underlying interest rate), refinance, and renegotiate existing loans, resulting in narrower spreads and, at times, larger loan balances and less favorable covenant protection. 

The changing dynamic in the bank-loan market created a challenging environment for active managers who are conscious of loan pricing, concerned about the balance-sheet impact of additional debt, and may be uncomfortable with changes to the underlying loan covenants.  Portfolio changes by active managers to avoid loans that are less attractive as a result of a new risk/reward relationship may be prudent, but can still result in downward pressure on portfolio yield. 

For bank-loan exchange-traded funds (ETFs) that are less concerned about valuation, financial metrics, and changes in loan covenants—and are primarily concerned with making sure portfolio holdings reflect a market index—the investment consequences could be more onerous both in terms of pressure on yield as well as impact on asset quality.

LIBOR Pains
As borrowers continue to negotiate more favorable loan terms, including a narrower margin over LIBOR, and in some cases shifting to lower-yielding one-month LIBOR as a base rate, investors must be concerned with the resulting impact on the yield of their bank loan-fund investment.  At the end of April 2017, the margin over LIBOR or bank loans had declined, from 385 basis points (bps) to 361 bps from year-end 2016, according to J.P. Morgan index data.  Much of that yield decline was balanced by an increase in the base rate, LIBOR, which rose from 1.00% to 1.17% over the period, according to Bloomberg.  But what can investors expect over the balance of 2017?

Analysis of refinancing and re-pricing activity provides some insights.  It is surprising that the margin over LIBOR did not fall more so in 2017, given the fact that some companies cut as much as 75–100 bps from the interest margins of existing loans.  The decline in average margin over LIBOR was likely contained by companies that did not have the opportunity to reprice or refinance or that took advantage of opportunities in 2016.  The fact that almost 80% of the $418 billion in new financing in the first four months of 2017 was for re-pricing or refinancing, compared with 65% of $485 billion in 2016, could imply that loan-margin pressures may have peaked. 

To that point, it is interesting to note that, according to J.P. Morgan, re-pricings already have trended lower in 2017: $66.2 billion in January, $53.1 billion in February, $45.2 billion in March, and $27.3 billion in April.  While additional bank loans could reprice or refinance over the balance of 2017, it may be argued that the largest refinancing benefits have been captured and that future additional margin tightening may be among fewer companies or could be more incremental, reducing the impact on loan margins.  For loans that now use one-month LIBOR instead of three-month LIBOR, the shift to the lower-yielding base rate was effectively a one-time yield reduction, as additional Fed rate hikes likely will push both rates higher over the course of 2017 and 2018.

A change in the supply/demand dynamic for bank loans also could affect a borrower’s ability to renegotiate loan terms.  A reduction in investor inflows could tilt pricing power away from borrowers, as could an increase in bank-loan activity related to corporate acquisitions or expansion.

Summing Up
The influx of retail investment to the bank-loan market, beginning in August 2016, coincided with reduced net new issuance of bank loans to empower existing borrowers to renegotiate more favorable terms on their bank-loan debt.  As investor interest subsides, and as better financing terms have already been negotiated, the future performance of bank loans may be less affected by future adjustments to loan margins.  With relatively attractive yield, minimal interest-rate volatility, and historically low default rates, bank loans continue to appeal to investors who anticipate slow and persistent Fed hikes and expect reasonable U.S. economic growth that will support continued lending. 

 

RELATED TOPICS

ABOUT THE AUTHOR

RELATED FUND
The Lord Abbett Floating Rate mutual fund seeks to deliver a high level of current income by investing primarily in a variety of below investment grade loans.

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