An Update on Floating Rate Bank Loans Amid Recent Market Volatility

Our expert assesses current market conditions—and the historical resilience of floating rate bank loans after periods of elevated volatility.

In Brief

• Floating rate bank loan prices recently came under pressure amid the broader market volatility engendered by the pandemic crisis, with the average loan price in the benchmark Credit Suisse Leveraged Loan Index falling below $80 in March before rebounding back above that level.
• But a look at market activity in the past three decades shows that, historically, loan prices have typically rallied sharply in the 12 months following instances where the average price dipped below $85.
• The recent market volatility has led to a large dispersion in valuations in bank loans—by rating, by deal size, by sector, and by individual credit. We believe this creates opportunities for active investors to potentially separate the winners from the losers.

Amid elevated market volatility, March 2020 was a difficult month for most asset classes. While U.S. Treasuries experienced a massive rally as yields reached all-time lows, equities suffered a historically significant pullback and credit spreads widened sharply as investors looked to price in the potential impacts on the economy from the coronavirus and efforts to mitigate its spread.

Floating rate bank loans were no exception, as the benchmark Credit Suisse Leveraged Loan Index (CS Loan Index) posted a negative return of -12.5%, the second worst monthly decline in index history, narrowly ahead of its -13.0% retreat in October 2008 amid the Global Financial Crisis (GFC).  The decline in March 2020 pushed the average price in the CS Loan Index to a low of $76.5 in late March before partially rebounding to end the month at $82.7, levels not seen since the 2008-09 period, as shown in Figure 1.

Figure 1. In March 2020, U.S. Bank Loan Prices Retreated to 2008-09 Levels
Average dollar price for the Credit Suisse Leveraged Loan Index, March 31, 1992-March 31, 2020

Source: Credit Suisse Leveraged Loan Index data as of 03/31/2020. 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.
 

Current Valuations
Reviewing month-end index data,¹ loan prices first fell below $83.0 in September 2008, (the month of the collapse of Lehman Brothers) as concerns about increasing defaults were exacerbated by waves of forced selling from over-leveraged investors across many sectors including high yield bonds, loans, convertibles, municipal bonds, and other asset classes. Loan prices fell further from there, approaching the low $60s in December 2008, but recovered relatively quickly, rising back above $84 by September 2009. In fact, in the 12-month period ending September 30 2009, the CS Loan Index delivered a positive return of 7.7%.

While some investors might only focus on the floating rate aspect of the asset class, bank loans provide exposure to below investment grade credit—although exposure that is senior to high yield bonds and secured by assets. Prices tend to decline during difficult credit environments, such as the bursting of the tech/telecom bubble in 2000, the downgrade of U.S. debt in 2011, and the energy and commodity crisis in 2015-16. However, in those periods, loan prices never fell below $85.0.

In the 338 months since the inception of the CS Loan Index in 1992, there have been only 15 months when the average price in the index was below $85.0 (or, only 4.4% of the time)—all occurring in the 15-month period between September 2008 and November 2009. Figure 2 summarizes the index returns in the one-year periods following each of those 15 months.

Figure 2. Historically, Price Declines below $85 Have Been an Attractive Entry Point for Bank Loan Investors
Data for the period March 31, 1992-March 31, 2020

Source: Credit Suisse Leveraged Loan Index data as of 03/31/2020. 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.

• The 7.7% return for the 12 months ended 9/30/09 was the lowest return, and the only instance of less than a double-digit return.
• The average return over these 15 instances was 24.4%, with the highest being 44.9% over the 12-month period ended December 2009.

Similar to the analysis on investing in high yield or equity markets during periods of extreme stress, prices might go lower in the near term, but looking at longer investment horizons, putting money to work at such depressed valuations has historically led to a positive outcome over longer holding periods.

An Evolving Landscape
Of course, some aspects of the loan market have changed over the past decade.

• There has been a shift in the rating mix of the CS Loan Index since September 2008, with a reduction in ‘BB’-rated loans and a greater emphasis on single ‘B’-rated issuers. However, there has been a large reduction in non-rated issues (only 3.6% of the index, versus 17.6% in September 2008), while exposure to ‘CCC’-rated loans remains modest, in our view.
• There has been a meaningful increase in “covenant lite” loans in the loan market. As a reminder, “covenant lite” does not mean “no covenants” at all. While loans may have fewer covenants, their credit agreements still contain many strin­gent requirements regarding the borrower’s financial condition and ability to meet principal and interest payments. In many cases, the covenant-lite nature of most of today’s loans could actually help issuers find extra time to work through their credit issues.
• There has been an increase in companies opting to borrow in the loan market over the high yield bond market, leading to an increasing proportion of “loan-only” borrowers. While loans maintain the senior position in a company’s capital structure, the increase in loan-only capital structures means there is less subordinated debt as a cushion below the senior position. While there has been some second-lien loan issuance through the past few years (subordinated to first-lien loans), this segment remains a small proportion of the overall credit risk outstanding in the loan market.

Given some of these trends, credit rating agency Moody’s lowered its expectations for recoveries on bank loans in the case of default in the next credit downturn to 61%, versus the long-term average recovery rate of 77%. We agree that there is the potential for lower recoveries on loans in the next default cycle.   However, “senior loans” remain senior in the capital structure, secured by assets and ahead of unsecured high yield bonds, so we believe loan recoveries in the case of default should continue to be above unsecured bonds, as they have been in prior years (see Figure 3).

Figure 3. Historically, U.S. Bank Loans Have Experienced Higher Recovery Rates than U.S. High Yield
Annual recovery rates, 1982-2019 (high yield bonds); 1990-2019 (bank loans)

Source: JP Morgan. Data as of December 31, 2019. 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.

One area that we believe is likely to see a large increase in defaults in the coming year, the high yield energy sector, makes up a relatively small part of the CS Loan Index (3.3% as of December 31, 2019) compared to the 12.5% weight in the high yield bond market.

So, as investors are looking to the credit markets to position their portfolios for a recovery from the current crisis, we think bank loans may be worth a closer look. While there is uncertainty across all markets, history might suggest that the current depressed valuations on bank loans offer an attractive entry point for investors with longer investment horizons.

One other consideration is the potential for technical pressures from retail mutual fund flows. However, retail investors have largely exited the asset class. The bank loan mutual fund category has experienced over $70 billion in cumulative outflows since the fourth quarter of 2018, leaving only about $70 billion in assets, or roughly 5% of the asset class, in the hands of retail investors. While flows can certainly have some impact, the large majority of the assets are held by collateralized loan obligations (CLOs) and other institutional investors with longer investment horizons.

Navigating the Market
The recent market volatility has led to a large dispersion in valuations in bank loans--by rating, by deal size, by sector, and by individual credit. We believe this has created opportunities for active investors to potentially separate the winners from the losers. We believe an active approach can allow our investment team to adjust the portfolio for the market environment, moving across the credit-quality spectrum, identifying those industries and individual issuers that present the best risk/reward opportunities, while potentially avoiding those issuers and deal structures that may pose risks to lenders.

Given the potential for credit issues lurking in the future, our view is that bank loans are not an asset class where a passive approach would be prudent. In our view successful investment in bank loans requires in-depth credit research by experienced analysts with a deep understanding of the issuers and industries in which they compete. We also believe that thorough covenant analysis, collateral analysis, and a strong grasp of the nuances of deal structures are vital to understanding one’s protections as a lender.

¹All loan price information presented herein is derived from Credit Suisse index data.