Getting Up to Date on Floating Rate

Even after a strong rally to start 2019, bank loans continue to offer the potential for attractive income and total return, along with portfolio diversification.

In Brief

• Floating-rate bank loans experienced volatility in late 2018, but have recovered strongly in the first four months of 2019.
• Meanwhile, the asset class continues to feature a long-term record of attractive risk-adjusted returns, along with a current default rate that is well below the historical average.
• Regardless of the future direction of interest rates, we believe bank loans remain an appealing option for investors seeking income, total return, and portfolio diversification.  

Market View last looked at floating-rate bank loans in early January, just as the equity and credit markets were emerging from a very difficult fourth quarter of 2018.  What has happened since? Like most other asset classes, bank loans have experienced a strong recovery in 2019 (through April 30) as many of the fears that we believe drove the late 2018 volatility have dissipated: namely, concerns about an over-aggressive U.S. Federal Reserve (Fed) tightening cycle, a prolonged trade war, and slowing global growth, particularly out of China.

Given the rebound, we thought it would be a good time to take a closer look at the asset class by examining some key metrics.

Performance
As mentioned earlier, the loan market bounced back in the first four months of 2019, with the benchmark Credit Suisse Leveraged Loan Index (the loan index) up 5.42% through April 30. While this has lagged the 8.90% rally in the ICE BofAML U.S. High Yield Bond Index during the same period, loans outperformed high yield by a significant margin during the risk-off environment last year.  Taken together, loans have provided similar returns to the high yield index since the beginning of 2018.  Relative to investment grade bonds, loans are well ahead of the 2.97% return of the Bloomberg Barclays U.S. Aggregate Bond Index.  This solid performance of floating rate came despite the decline in U.S. Treasury yields this year, which has provided a tailwind to longer duration, investment-grade bonds.

Taking a longer-term view, despite persistent negative investor sentiment surrounding the asset class, bank loans have provided higher risk-adjusted returns than both investment-grade and high-yield bonds over the past three and five years (see Chart 1), as loans have had higher returns than investment grade bond and lower volatility than high yield, resulting in a higher Sharpe ratio than either bond index.

Chart 1. U.S. Bank Loans Have Provided Attractive Risk-Adjusted Returns in Recent Years
Average annual return, standard deviation (volatility), and Sharpe ratio for the indicated periods through April 30, 2019 (three-year period for scatter plot)

Source: Morningstar. Bank Loans=Credit Suisse Leveraged Loan Index. High Yield=ICE BofAML U.S. High Yield Index. US Aggregate Bond=Bloomberg Barclays U.S. Aggregate Bond Index.
The information shown is for illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged and are not available for direct investment. Past performance is not a reliable indicator or a guarantee of future results.

Valuations
As most markets came under significant selling pressure at the end of 2018, the average price in the loan index declined by about 4.5 points to $94.10. The index has since recovered about 75% of the price drop, but the average price in the index remains over a point below the highs from last October (see Chart 2).
 

Chart 2.  U.S. Bank Loan Prices Remain below Recent Highs
Credit Suisse Leveraged Loan Index average US$ price, April 30, 2014–April 30, 2019Source: Credit Suisse. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Past performance is not a reliable indicator or guarantee of future results. Due to market volatility, the asset class depicted in this chart may not perform in a similar manner in the future. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

But prices cannot be viewed in a vacuum: for loans, the coupon income is typically the major driver of total returns.  While the average coupon in the loan index has come off its recent highs, following the recent decline in the benchmark LIBOR rate, the average coupon in the index remains above 6.1%. That’s near the highest levels since before the financial crisis in 2008-09, providing attractive current income in today’s environment (see Chart 3).

Chart 3. The Recent Climb in U.S. Bank Loan Coupons Offers the Potential for Higher Income
Average coupon rate in the Credit Suisse Leveraged Loan Index, April 30, 2014–April 30, 2019Source: Credit Suisse. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Past performance is not a reliable indicator or guarantee of future results. Due to market volatility, the asset class depicted in this chart may not perform in a similar manner in the future. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Credit Environment 
The credit environment for below-investment grade issuance remains extremely benign, in our view.  As of April 30, the trailing 12-month default rate for bank loans was 1.29%, well below the long term average (see Chart 4).  In our base case scenario of continued positive growth in the U.S. economy, defaults are expected to remain low.

Chart 4. U.S. Bank Loan Defaults Are Near Multi-Year Lows
U.S. leveraged loan default rate, April 30, 2003–April 30, 2019

Source: J.P. Morgan. Data as of April 30, 2019.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

Supply and Demand
One of the issues facing bank loans has been the technical headwinds from mutual fund flows.  Retail investors appear to have taken a one-dimensional view on the asset class: they tend to tactically allocate to loans as they perceive rates are heading higher, and then exit their positions as their rate predictions change.  While bank loans historically have delivered high current income, attractive risk-adjusted returns, and portfolio diversification benefits given their negative correlation with investment grade bonds, many retail investors tend to focus solely on loan coupons’ adjustment to interest rates.  Bank loan mutual funds have been in consistent outflows since October 2018, based on data from Lipper, with $34 billion in net outflows from October 2018 through the end of April 2019. Encouragingly, those outflows have diminished substantially in recent weeks, suggesting this headwind may be dissipating.

But few seem to be aware that mutual funds only make up about 10% of the asset class.  Over half of the market is held by collateralized loan obligations (CLOs).  According to data from J.P. Morgan, net issuance of CLOs has totaled $45 billion year to date through April 30, 4% ahead of last year’s pace, creating demand that has more than offset the $13 billion in mutual fund outflows over that period.  Meanwhile, from a supply standpoint, net new issuance of bank loans of $66 billion is down sharply from last year, a decline of 28% from last year’s pace.

Going Forward
The relatively strong performance of the equity and credit markets so far in 2019 would seem to suggest that the volatility in the fourth quarter may have been an over-reaction to some of the potential risks in the market at the time.  As the markets seem to have become more comfortable with the intentions of the Fed and the pace of economic growth, the “risk-off” sentiment has been reversed and the markets have recovered quite dramatically.

We believe that the fears of an impending recession have been overblown, and most economic indicators point to a continuation of positive economic growth. This environment of positive economic growth—but not growth at a pace that is robust enough to trigger an uptick in inflation or aggressive Fed tightening—presents a very positive backdrop for credit, including high yield bonds and bank loans.  In this environment, defaults should continue to remain low, and spreads have the potential to tighten further from here.     

While bank loans have had a strong rally this year, they have not kept pace with the historic start to the year in high yield. With that move, the loan market is in the unusual situation of offering higher yields than the high yield bonds, despite their senior, secured position relative to bonds.  In other words, for those investors looking for sources of yield and diversification for core bond allocations, bank loans can provide higher yields and wider spreads than high yield bonds, while moving up to a senior position in the capital structure.

Table 1. Bank Loans Recently Offered Higher Yields than High Yield
Data as of April 30, 2019

Source: Credit Suisse and ICE Data Indices. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Past performance is not a reliable indicator or guarantee of future results. Due to market volatility, the asset class depicted in this chart may not perform in a similar manner in the future. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

So far this year, mutual fund flows would suggest retail investors have had a renewed appetite for high yield bonds, but sentiment seems to be negative toward bank loans. Part of the negative sentiment comes from a view on rates: if the Fed is likely to remain on hold for the foreseeable future, and perhaps even cut rates, some would say that there is little incentive to own floating rate loans. Given their high current income, and an anticipated environment of continued low defaults, we believe that loans have the potential to deliver attractive returns without the benefit of rising rates.

Bank Loans: Much More Than an Interest-Rate Play
It was just a few months ago that the consensus view held the belief that the Fed was likely to raise rates another three times in 2019. Today, the consensus seems convinced that the Fed is on hold, or may even cut rates. What are the chances the popular view on rates may change once again in the next six months?  Would it not make sense to have some portion of your portfolio allocated to bank loans to diversify fixed income portfolios, generate attractive income regardless of what the Fed does next, and potentially benefit from rising rates in the future?

In that regard, we think a professionally managed portfolio of floating-rate bank loans—which can provide a source of high current income, with a history of delivering attractive risk-adjusted returns, and potential portfolio diversification benefits given their low correlation with other asset classes—deserves strong consideration.