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Market View

Floating-rate bank loans offer the potential of attractive income in today’s low-yield environment.

 

In Brief

  • Despite modest returns so far in 2017, bank loans have delivered strong returns, relative to most investment-grade bonds, over the past 12 months. [Although, historical performance is no guarantee of future results.]    
  • Lower spreads from refinancing activity have offset a rising London interbank offer rate (LIBOR), limiting the increase in coupon rates. But loans still offer the potential of attractive income in today’s low-yield environment.
  • LIBOR may be phased out as the primary reference rate for many financial instruments. This transition will take many years, and should have no impact on the current bank-loan market.

 

As we come to the unofficial end to summer on Labor Day, this week’s Market View highlights the performance of the bank-loan market relative to other fixed-income asset classes. Looking back one year ago, interest in the asset class was increasing, as longer-term U.S. Treasury yields had begun to rise off their low point reached in early July 2016, and investors looked to position themselves for a potential rising-rate environment. What has happened since?

In the following, we take a look at the bank-loan market to date and address some of the questions currently on investors’ minds.

How Have Loans Performed?
As summarized in Chart 1, the floating-rate bank-loan asset class (as measured by the Credit Suisse Leveraged Loan Index) has returned 2.6% year to date, trailing the 3.6% return of the broader fixed-income market (as represented by the Bloomberg Barclays U.S. Aggregate Bond Index). As was the case in 2016, lower-quality loans have led the way, with the ‘CCC’ rated portion of the leveraged loan index generating a 5.2% return year to date, well ahead of the 1.9% return of the ‘BB’ rated component of the same index.

At first glance, this year-to-date return may seem disappointing relative to the broader fixed-income market. But this performance requires some context, in light of the market environment of the past 12–15 months. In brief, before looking at 2017, one must not forget what happened in 2016.

During the last six months of 2016, a rapid rise in Treasury yields led to steep losses in most longer-duration investment-grade bond sectors, including a 7.5% loss for the 10-year U.S. Treasury bond and a negative return of 2.5% for the Bloomberg Barclays U.S. Aggregate Bond Index. During this same six-month period, bank loans, which do not have the same interest-rate risk of traditional fixed-rate bonds due to their floating-rate coupon, have delivered a positive return of 5.4%, owing to a combination of current income and price appreciation. [Due to market volatility, the market may not perform in a similar manner in the future.]

This year has presented a different environment for fixed-income investors. Indications of diminished inflationary pressures, and lowered expectations that the Trump administration will successfully implement many pro-growth policies, have led market participants to reduce their expectations for future rate hikes. This has led to lower Treasury yields, providing a tailwind to longer-duration assets, leading to strong performance versus bank loans.

This reversal in relative performance in 2017, compared with the latter half of 2016, is a good illustration of why bank loans offer diversification benefits to a core-bond allocation and can play, we believe, a valuable role in a fixed-income portfolio. Since floating-rate loans have negative correlation with investment-grade bonds, adding loans to a core bond portfolio historically has reduced overall portfolio volatility.  

 

Chart 1. Since Last Summer, Bank Loans Have Outperformed Core Bonds…
Data for the period June 30, 2016–August 31, 2017

…and Most Investment-Grade Asset Classes
Total return for indicated periods  

Source: Bloomberg Barclays, BofA Merrill Lynch, and 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 illustrated 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 are not available for direct investment.

 

How Have Coupons Floated?
While we have outlined the many potential benefits of bank loans on several occasions—namely, high current income, low duration risk, attractive risk-adjusted returns, and portfolio diversification—many investors focus only on the allure of higher income in the face of a rising-rate environment. The main reference rate for floating-rate loans, the three-month LIBOR, has moved higher over the past two years, following the increase in the fed funds target rate. However, the coupon rates on floating-rate loans have not kept pace. What has happened?

Borrowers have taken advantage of the strong demand for loans and the favorable environment for credit by refinancing their outstanding loans at lower spreads. As a result, higher LIBOR rates have been offset by lower spreads from refinancing, leading to a relatively stable average coupon rate in the loan index, at just below 5%. While coupons have not floated higher as many investors had hoped, the income generated by loans has remained attractive relative to most investment-grade asset classes, which come with much greater duration and interest-rate risk.

 

Chart 2. Income Generated by Loans Has Remained Steady as Most Yields Have Declined
Data in bar chart from December 31, 2016–August 31, 2017; yield data in table as of indicated dates

Source: Bloomberg Barclays, Credit Suisse, and BofA Merrill Lynch.  Bank loan yield represents average coupon; all other index yields are yield to worst. 1Represented by the Credit Suisse Leveraged Loan Index. 2Represented by the Bloomberg Barclays U.S. Treasury 10-Year Bond Index. 3Represented by the BofA Merrill Lynch BBB-Rated U.S. Corporate Index. 4Represented by the BofA Merrill Lynch U.S. High Yield Constrained Index.
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 illustrated 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 are not available for direct investment.

 

Will LIBOR Be Retired, and Will That Affect My Bank-Loan Portfolio?
Questions about the future of LIBOR have increased since a late-July speech by Andrew Bailey, the chief executive of the Financial Conduct Authority (FCA), the regulatory agency responsible for the oversight of LIBOR. He suggested that the FCA would no longer compel banks to provide LIBOR submissions after the end of 2021. (LIBOR currently is calculated using average borrowing rates submitted by a panel of lenders each morning.) The common question has been, “Will this affect my bank-loan portfolio?” The short answer is, not at all.

Most issues in the leverage-loan market—which totals approximately $1 trillion in assets—have coupons that float based on a spread over LIBOR. But LIBOR is the reference rate for hundreds of trillions of dollars of financial instruments, including consumer loans, mortgages, and interest-rate derivatives, so there is a much broader impact beyond the leverage-loan market. Any transition away from LIBOR as a standard reference rate would need to be slow and gradual to avoid any unnecessary disruption to the financial system.

In fact, the transition away from LIBOR has been discussed for several years. For example, in order to improve transparency and stability in the markets, the U.S. Federal Reserve convened the Alternative Reference Rates Committee three years ago in order to identify an alternative set of reference rates that could replace LIBOR as the standard and to make plans for the adoption of these rates.

In short, the markets have known that LIBOR eventually will be replaced; the target date of 2021 provides a long period for an orderly transition to a new benchmark rate. While bank loans commonly are issued with a seven-year final maturity, the average life typically is closer to three years, given that loans are commonly prepaid or refinanced prior to final maturity. As a result, most loans that are in the market today will be retired well before 2022.

Going Forward
Today’s market expectations for the pace of future rate hikes may be different from what it was a year ago. Regardless of what happens with the direction of short-term interest rates, however, bank loans still deserve consideration as part of a diversified fixed-income portfolio, offering investors the potential for:

  • Attractive income relative to most investment-grade asset classes
  • Less duration risk than traditional fixed-rate bonds
  • Lower volatility than high-yield bonds
  • Attractive risk-adjusted returns relative to other fixed-income asset classes
  • Valuable diversification benefits, given their negative correlation to investment-grade bonds

 

MARKET VIEW PDFs


  Market View

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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