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Market View

Media reports on U.S. floating-rate loans are missing the bigger picture. Here, we provide some necessary context.

Investor sentiment can be very fickle when it comes to bank loans. Amid heightened fears of rising U.S. interest rates, floating-rate mutual funds and exchange-traded funds that invest in bank loans took in more than $75 billion in net inflows over a 15-month stretch from January 2013 through March 2014, according to Morningstar. That torrent quickly reversed, with nearly $60 billion in assets flowing out of the category over the following 27 months, as declining U.S. Treasury yields provided a tailwind for longer-duration assets. 

With renewed evidence of inflationary pressures and higher rates picking up in the summer of 2016, the flows reversed course once again, with bank-loan funds gaining assets almost every week since July 2016, for a cumulative inflow of $32 billion (July 2016–May 2017).  

The volatility in flows would suggest that most retail investors view bank loans as only a tactical call on the direction of interest rates. We believe this approach is misguided. Bank loans’ historical positive performance during periods of rising rates is a benefit to consider when investing in the asset class—but it is not the only factor in its favor. Here are some other reasons to consider the asset class:

  1. High income potential—With a yield of approximately 5.0%, at June 21, 2017 (based on the Credit Suisse Leveraged Loan Index), bank loans recently provided roughly twice the income of the Bloomberg Barclays U.S. Aggregate Bond Index (“Barclays Aggregate”), and more than double the yield of  the 10-year U.S. Treasury note. Given the ultra-low duration of floating-rate loans, the income advantage is even more extreme when their yield is compared to similar-duration Treasury bills, which recently offered yields of roughly 1.0%.
  2. Historically low duration—Floating-rate coupons allow bank loans the opportunity to benefit from rising short-term rates. But this feature of loans also leads to limited interest rate exposure to protect from rising rates.  In other words, even if short-term rates stay low, and loan coupons do not adjust higher, the lack of duration protects loans from the negative effects of rising long-term interest rates. For example, think back to the fourth quarter of 2016, when the yield on the 10-year U.S. Treasury jumped by 100 basis points (bps), leading to a loss of approximately 3.0% for the Barclays Aggregate. During this period, the Credit Suisse Leveraged Loan Index (“Leveraged Loan Index”) generated a positive return of +2.25%, without benefitting from higher short-term rates (the average coupon for the index remained stable at 4.9% during the quarter).
  3. Portfolio diversification—The fourth-quarter 2016 performance outlined above illustrates the historical negative correlation of bank loans with investment-grade bonds. Since performance is driven by different factors, bank loans tend to “zig” when investment-grade bonds “zag.”  As a result of this negative correlation, a combination of the two asset classes has the potential to provide attractive income with reduced volatility. Chart 1 depicts the five-year return and volatility for a range of floating-rate/Barclays Aggregate percentage blends. For example, a blended portfolio of 50% bank loans and 50% Barclays Aggregate historically has had lower volatility than the Aggregate index on its own. This comes as a surprise to many investors: adding a “risky” asset class to their core bond holding can potentially reduce the risk of their overall bond portfolio. [See below for important information on investment risk for this asset class.]  
  4. A long-term record of risk-adjusted returns—Some media reports have highlighted that bank loans have lagged high-quality bonds so far this year, as longer-duration assets have rallied amid declining interest rates. But this focus on short term-performance misses the bigger picture. Historically, loans have outperformed the Barclays Aggregate over the trailing one-, three-, and five-year periods. And due to their low volatility, floating-rate loans have generated higher risk-adjusted returns (as measured by Sharpe ratio) than either high-yield or investment-grade bonds over the past five years, according to data from Zephyr (see Chart 2). 

 

Charts 1 and 2. Historically, Bank Loans Have Enhanced Portfolio Diversification…
Data for the period February 1, 1992–May 31, 2017

… While Providing Attractive Risk-Adjusted Returns on Their Own
Trailing five years, as of May 31, 2017

Source: Zephyr (Chart 1); Credit Suisse, Bloomberg Barclays, and Bank of America (Chart 2).
Past performance is no guarantee of future results. Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses and expenses, and are not available for direct investment.

 

Addressing the Covenant Question
There have been a number of recent articles in the financial press highlighting the potential risks of the asset class. One frequent topic is the prevalence of “covenant-lite” loans. Covenants are part of the credit agreement between borrowers and lenders that spell out the terms of the loan and the obligation of the borrower, thus providing protection to the lender. Over time, so-called “cov-lite” loans, which typically have fewer restrictions than conventional loans, have become a larger part of the market, and now account for more than 70% of the Leveraged Loan Index. 

While investors would always prefer more lender protection, a few points should be kept in mind:

  • “Covenant lite” does not mean “no covenants” at all. Covenants come in many forms, including affirmative, which spell out what the borrower must do; negative, which limit the company’s ability to take certain actions that could be credit negative; and financial, which enforce minimum levels of financial performance the company must maintain. While covenant-lite 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.
  • Covenants alone, however, imply very little about the overall credit risk of a loan. Other financial measures, such as leverage, interest coverage, collateral valuation, credit rating, use of proceeds, and, from a broader perspective, industry dynamics and the competitive position of a company, provide greater insight to the credit risk of a deal. 
  • It is interesting to note that the average yield spread on the covenant-lite portion of the Leveraged Loan Index is more than 40 bps lower than loans with full covenants (see Chart 3). This suggests that investors demand full covenants from lower-quality deals, while higher-quality loans can come to market without full covenant protection. If the cov-lite label on its own implied higher credit risk, the market would demand higher yields for such loans.  

 

Chart 3. Covenant Lite Loans Recently Featured Lower Spreads Than Full-Covenant Counterparts
Data as of May 31, 2017

Source: Credit Suisse.
Past performance is no guarantee of future results. Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses and expenses, and are not available for direct investment.

 

This does not mean that covenant protection should be ignored. As with any strategy focused on below investment-grade credit, fundamental research is a key component of successful investing. An understanding of covenant protection should be a part of the research process. Deteriorating credit fundamentals, which may increase the chance of default by the issuer, or declining collateral value can adversely affect the price of loans. In addition, since loans can be refinanced or redeemed early by the issuer, thorough prepayment risk analysis is required. For this and many other reasons, this not an asset class that is conducive to passive investing.

Lord Abbett devotes considerable research resources to its bank-loan strategy. In addition to in-depth credit research, thorough covenant analysis, collateral analysis, and prepayment risk analysis are all key components of our investment process. Since bank loans may be less liquid than investment-grade bonds, we construct broadly diversified portfolios, limiting industry and issuer concentration. Our investment process and approach to risk management has been informed by over four decades of investing in the debt of below investment grade companies. 

Summing Up
Due to some key misperceptions of the bank-loan market, many investors react to the sentiment of the day and try to time the market by moving in and out of the asset class. But a thorough review of the potential benefits of bank loans—attractive income, lack of interest-rate sensitivity, attractive risk-adjusted returns, portfolio diversification, and performance during rising rates—would suggest that floating-rate loans deserve a role in a diversified fixed-income portfolio.

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

CONTRIBUTING STRATEGIST

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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