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Market View

U.S. bank loans historically have offered attractive income, and the potential for portfolio diversification, in a variety of interest-rate environments.

Recent moves in the three-month London Interbank Offered Rate (LIBOR) have garnered much attention. As Zane Brown, Lord Abbett Partner and Fixed Income Strategist, recently observed, the latest uptick in LIBOR rates likely was triggered by side effects of upcoming regulatory changes for U.S. money market funds. This has pushed the three-month LIBOR up to its highest levels since 2009, reaching 0.83% as of August 26, according to Bloomberg. Investors in U.S. floating-rate loans (also known as bank loans) have been following these developments closely, as LIBOR moves have significant implications for the asset class, which we will address below.

For most of 2013 through mid-2015, as the U.S. Federal Reserve (Fed) kept its target fed funds rate in the 0–0.25% range, three-month LIBOR was stuck in a fairly tight range of 0.22–0.30%. As the Fed finally started the “lift-off” in its target rate at the end of 2015, LIBOR adjusted higher, to trade in the 0.60–0.65% range for much of 2016, until July’s 15 basis-point move. But how has LIBOR acted over the long term?

Take a look at Chart 1, which compares the three-month LIBOR versus the fed funds rate over the past 24 years. (The average coupon on the Credit Suisse Leveraged Loan Index is also shown.) You generally will see a fairly tight relationship between the two rates, with LIBOR moving in lockstep with fed funds. While there have been certain short-term periods where the rates diverge (such as 2008), LIBOR typically has traded about 25 basis points above the fed funds rate.

 

Chart 1. LIBOR and Fed Funds Rates Historically Have Moved in Lockstep
Three-month LIBOR, fed funds rate, and average coupon on the Credit Suisse Leveraged Loan Index, July 1992–July 2016



Source: Bloomberg and Credit Suisse. Leveraged loans represented by the Credit Suisse Leveraged Loan 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 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.
Floating-rate loans are lower-rated, higher-yielding instruments, which are subject to increased risk of default and can potentially result in loss of principal. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. No investing strategy can overcome all market volatility or guarantee future results.

 

When focusing in on periods where the Fed was raising the fed funds rate (in 1994, 1999, and 2004–06), note that LIBOR adjusted in sync (see supplemental chart).

What Does This Mean for Floating-Rate Loans?
Floating-rate loans get their name because of their adjustable-rate coupons. While traditional fixed-income securities feature fixed coupons, loans are issued with coupons that will adjust with short-term interest rates, typically based on some spread over LIBOR. Let’s say a loan was issued with a coupon of LIBOR plus 3.75%. If LIBOR was 0.50%, the loan would pay a coupon of 4.25%. If LIBOR rose to 1.00%, the loan’s coupon would “float” higher, to pay 4.75%. As illustrated in Chart 1, the average coupon in the loan market has adjusted to the up and down moves in LIBOR.

This coupon structure provides floating-rate loans (and the mutual funds that invest in such loans) key benefits, including providing attractive income without the interest-rate risk of traditional fixed-rate bonds. While traditional fixed-rate securities such as U.S. Treasury bonds tend to decline in price during periods of rising interest rates, floating-rate loans actually benefit from rising rates as their coupons adjust higher. Because of this, they historically have had negative correlation with high-quality bonds (as represented by the Barclays U.S. Aggregate Bond Index); thus, loans can provide valuable diversification benefits when added to a portfolio (see supplemental chart).

Over longer time periods, floating-rate loans generally have lagged the performance of the high-yield bond market. However, loans generally exhibit lower volatility than high-yield bonds, given their floating-rate nature and their seniority in a company’s capital structure. In fact, the standard deviation of floating-rate loans (based on the Credit Suisse Leveraged Loan Index) historically has been approximately 30% lower than the Credit Suisse High-Yield Bond Index, leading to higher risk-adjusted returns for loans over the past three- and five-year periods—a period of low and declining interest rates.

Many retail investors have shied away from this market in recent years, as the Fed had seemed committed to keep rates near zero for an extended period of time, leaving little hope for LIBOR to move higher. In focusing solely on the likelihood of interest-rate moves by the Fed, these investors appear to have disregarded the other benefits the asset class has to offer—namely, attractive income, low duration, and portfolio diversification.

In addition, most of the loan market now has “LIBOR floors” in place that would delay those loans coupons from moving higher. Since rates have been so low in recent years, most loans were issued with a floor, or a minimum rate that LIBOR was assumed to be for calculating the coupon payment. For example, if a loan was issued with a coupon of LIBOR plus 3.75%, and a LIBOR floor of 1.00%, the loan would pay a coupon of 4.75% even if actual LIBOR was only 0.50%. This would generate a higher current income; however, the coupon would not begin to “float” until LIBOR moved above the 1.00% floor. Some investors had argued—erroneously, we believe—that these floors were a reason to avoid the asset class.

But with the recent moves in LIBOR, loans are beginning to trade above their floors. For example, according to Standard & Poor’s, approximately 24% of the loan market has LIBOR floors of 0.75%. With another 8% of the market with no floor, roughly one-third of the loan market will now begin to float with additional upward moves in LIBOR. The majority of the loan market (62% of the market, as illustrated in Chart 4) has a floor at 1.00%, so just one 25 basis-point move would result in LIBOR trading above the floor for approximately 95% of the loan market.

 

Chart 2.  What’s the Floor Plan for the U.S. Bank-Loan Market?
Breakdown of U.S. loan market, by LIBOR floor level

Source: Standard & Poor’s.
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.
Floating-rate loans are lower-rated, higher-yielding instruments, which are subject to increased risk of default and can potentially result in loss of principal. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan’s value. No investing strategy can overcome all market volatility or guarantee future results.

 

What’s Next?
So, should investors expect a rapid rise in LIBOR going forward? Not necessarily. Given the uncertainty surrounding money-market reform, LIBOR may remain somewhat elevated. But from a broader perspective, a dramatic rise in short-term rates still seems unlikely in the near term. However, market expectations for Fed actions have been increasing.  With an improvement in recent employment numbers along with rhetoric from several Fed board members, the probability of a September rate hike has moved from near zero in early July to 42% as of August 26, according to Bloomberg. And futures markets are now pricing in a 65% chance of at least one rate hike by the December meeting. The yield on the two-year Treasury, which is highly sensitive to the outlook on Fed policy, also has risen, from below 0.60% in July to 0.84% as of August 26.

Over time, the fed funds rate—and LIBOR along with it—should adjust higher as the Fed looks to normalize policy. The move may be slow and gradual, given the likelihood that the global economy will remain in the slow-growth, low-inflation environment it has been stuck in for several years. As rates adjust higher, the coupon on most floating-rate loans will begin to move higher in tandem, as LIBOR moves above the level of most LIBOR floors.

But the spotlight on LIBOR also should bring a renewed interest in floating-rate funds. The benefits of the asset class remain: high income without the duration of traditional bonds; diversification benefits due to negative correlation with fixed-rate bonds; and attractive, risk-adjusted returns. Now, with the perceived impediment of LIBOR floors potentially being removed, the asset class may benefit from an increase in flows into floating-rate mutual funds, thereby improving the supply/demand technical backdrop for loans. This trend has already begun, with flows into the Lipper bank loan fund category turning positive in July; and as of August 24, flows had been positive in each week of August. The $299 million into the Lipper Bank Loan category for the week ended August 24 was the second largest weekly inflow into the asset class since April 2015.

We have argued for some time that loans deserve consideration as part of a diversified fixed-income portfolio, whether or not you expect rates to rise in the near term. With the recent moves in LIBOR, we may be closer to seeing the benefits that floating-rate loans can offer during periods of rising rates. 

But investors should not blindly invest in the asset class merely because of expectations of rising rates.  Like high-yield bonds, loans are another form of borrowing by below-investment-grade companies. Although bank loans are senior to high-yield bonds, successful investment in loans cannot be achieved using a passive approach. We believe it requires fundamental credit analysis and a deep understanding of the nuances of the loan market, and, therefore, investors may wish to consider the benefits of employing a manager with a long history of investing in credit instruments, such as bank loans, and which utilizes a disciplined process based on in-depth research and rigorous risk management. Experienced investment managers can take a more opportunistic approach, and can adapt to the market environment in order to position the portfolio in sectors and in individual credits that offer the best risk-reward profiles.

 

MARKET VIEW PDFs


  Market View
  U.S. Market Monitor

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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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