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Market View

The asset class has offered attractive income and less interest-rate risk than other fixed-income strategies.

Floating-rate funds (also known as senior loan or bank loan funds) historically have offered a relatively attractive income stream, while presenting less interest-rate risk than traditional, fixed-rate bond strategies. But their popularity has waned in the past year. Net fund flows from retail investors have been negative for the last 12 months, according to Lipper.

Indeed, the direction of interest rates (as measured by the yield on the 10-year U.S. Treasury note) can have a significant influence on investment flows into the retail bank loan mutual funds. (See Chart 1.) Floating-rate funds received strong inflows as Treasury yields rose in 2012–13 amid fear of continued higher rates, leading to negative returns for fixed-rate bonds, including a 7.8% decline for the 10-year U.S. Treasury note in 2013, according to Bloomberg. In 2014, interest rates fell, leading to a 10.7% positive return for the 10-year Treasury. With the prospect of higher interest rates seemingly pushed out into the future, demand for floating-rate securities from retail investors diminished. Flows turned negative in 2014 as longer-duration asset classes rallied. Recently, interest rates moved higher, and the outflows stabilized.

Interest-rate confusion among investors appears to shoulder much of the blame. Amid the uncertainty regarding the U.S. Federal Reserve’s strategy for normalizing interest rates, “it seemed as if each time [Fed] policymakers spoke of ‘patience’ regarding the timing of the first increase in the fed funds rate, another $1–2 billion of retail cash left the leveraged-loan market,” said Lord Abbett Investment Strategist Brian Arsenault.

 

Chart 1. Interest-Rate Changes Have Driven Loan-Fund Flows
Investment flows into leveraged-loan mutual funds and exchange-traded funds versus the yield on the 10-year U.S. Treasury note, second quarter 2012–first quarter 2015 (through March 27); quarterly returns on select fixed-income indexes during that time

*Through March 27, 2015.
Source: JP Morgan, Lipper, Bloomberg (chart); Barclays and Credit Suisse (table). "10 Year UST Yield" refers to the yield on the 10-year U.S. Treasury note. Leveraged loan returns represented by the Credit Suisse Leveraged Loan Index. High yield returns represented by the Credit Suisse High Yield Index. Barclays Aggregate refers to the Barclays U.S. Aggregate Bond Index.
The historical data are for illustrative purposes only, do not represent any Lord Abbett product 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.

 

But fund outflows and the actual performance of the asset class are two entirely different things. As the table accompanying Chart 1 indicates, floating-rate securities have outperformed high-yield bonds during “risk off” periods when credit spreads have widened, and core bonds during times when interest rates have risen. Historically, bank loans (as represented by the Credit Suisse Leveraged Loan Index) have delivered positive annual calendar-year returns for 22 of the past 23 years, based on data from Credit Suisse, with only 12 calendar quarters of negative returns out of 92 quarters in the period. [Due to market volatility, the market may not perform in a similar manner in the future. Performance during other time periods may have been different or negative.]

As we get closer to a potential interest-rate” liftoff” from the Fed later in 2015, investors may want to take a fresh look at floating-rate. Zane Brown, Lord Abbett Partner and Fixed-income Strategist, noted that in each of the last three intervals of Fed rate hikes since 1994, bank loans outperformed both the Barclays U.S. Aggregate Bond Index (which is a broad barometer of the U.S. fixed-income market) and the two-year U.S. Treasury note. 

While outflows slowed significantly in February and March, the extended negative streak may have given many investors pause. Could an extended period of fund withdrawals by retail investors cause significant damage to the market? As it turns out, those worries appear to be overblown. As Chart 2 shows, mutual funds account for only about one-fifth of the leveraged-loan market. The balance of the market is accounted for by institutional investors, including purchasers for the collateralized loan obligation (CLO) market. 

 

Chart 2. Mutual Funds Account for Less Than 20% of the $800 Billion Loan Market
Share of the U.S. bank loan market by ownership category, as of December 31, 2014

Source: J.P. Morgan. CLOs refer to the collateralized loan obligation market.

 

The fund outflows may be overshadowing positive fundamental and technical factors that are present in the leveraged-loan market. Corporate credit fundamentals have been favorable, as the slowly improving U.S. economy has contributed to strong corporate earnings, noted Arsenault. This has allowed issuers to improve their balance sheets gradually over the course of the past year.

Meanwhile, the technical picture for the leveraged-loan market remains favorable, said Arsenault. A recent Wall Street Journal article pointed out that regulatory changes have prompted banks to slow lending for leveraged merger and acquisition (M&A) deals.1 About $26.5 billion in leveraged loans for U.S. private-equity buyouts and refinancings have been issued so far this year—an 82% decline over the same period in 2014 and the lowest level since 2009, according to Dealogic data cited in the article.

But this reduced supply comes as buying demand for leveraged loans from institutional investors is actually increasing. A Reuters report cited strong investor demand for a $700 million leveraged-acquisition loan from cereal maker Post Holdings.2 Reuters said investors' enthusiasm for the deal was “due to a lack of new primary deals to invest in and the continued creation of…collateralized loan obligation (CLO) funds.”

We’ve noted elsewhere that floating-rate loans may provide attractive income without the duration risk of fixed-rate bonds, with less volatility than high-yield bonds or equities. They also may supply a source of portfolio diversification, given the low or negative historical correlation of floating-rate loans with other major asset classes.

What else should investors know about the bank loans? Arsenault noted that yield spreads for leveraged loans (as represented by the Credit Suisse Leveraged Loan Index) compared to the London Interbank Offered Rate (LIBOR) were recently above their long-term average. As the Fed approaches a “liftoff” of the fed funds rate sometime in 2015, concerns about rising interest rates and attractive valuations should draw investors back into the asset class, he said.

 

1Gillian Tan, “Buyout Firms Feel Pinch From Lending Crackdown,” The Wall Street Journal, March 25, 2015.
2Jonathan Schwarzberg, “TRLPC: Investor Demand Strong for Highly Leveraged U.S. Loans,” Reuters, March 27, 2015.

 

MARKET VIEW PDFs


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  U.S. Market Monitor

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