A Compelling Case for Leveraged Loans
In the current environment, there are several compelling reasons to invest in leveraged loans. From a fundamental perspective, a fairly supportive economic background should allow companies to continue to meet their targets. Additionally, we believe the four factors below suggest that leveraged loans could outperform other fixed income categories.
- Inflation may be on the upswing. Leveraged loans may provide some protection because interest rates typically follow, and the coupon rates on leveraged loans typically reset every 90 days. In addition, unlike conventional fixed income securities, loan prices are unlikely to fall when interest rates rise.
- The London Interbank Offered Rate (LIBOR) has been rising, largely as a result of new regulations on prime money market funds. If rates rise, LIBOR could rise even further.
- Defaults have declined. Most defaults that occurred year-to-date 2016 were in two sectors, Energy and Metals & Mining. With the rebound in commodities prices, these sectors are recovering.
- Retail investors are returning to the market; after many months of outflows from leveraged loan mutual funds, flows have turned positive. Additionally, the supply of new loans remains robust, helping to keep valuations from climbing further.
The Federal Open Market Committee (FOMC) is widely expected to raise the fed funds rate at its December 14, 2016, meeting. The FOMC’s own projections suggest two hikes are in store for 2017.
Leveraged loans offer coupons that periodically reset in relation to a base rate, usually LIBOR. Because of their floating rate feature, these loans are typically valued for their ability to protect investors during periods when the FOMC raises short-term rates.
There are many reasons to invest in this asset class, including these four factors:
1. Inflation may be rising
Demand for leveraged loans suffered as interest rates sunk lower in recent years, and the overall trend in the economy has been sluggish, if not deflationary. But commodity prices rebounded from earlier in 2016 and wages rose, so investors are beginning to see signs of inflationary pressures. As of September, the Consumer Price Index was up 1.5% year over year, the largest increase since 2014.
Bond market yields have responded by edging higher in recent months. (Bond prices move inversely to yield.) As of November 17, the yield on the 10-year Treasury was 2.29%, over 90 basis points from its alltime low on July 8, 2016.
If higher inflation and interest rates are in store, investors would be wise to consider leveraged loans. Historically, leveraged loans have performed well when interest rates start to ascend as shown in Exhibit 1.
Exhibit 1: In Rising Interest Rate Environments, Leveraged Loans Posted Positive Returns in 15 out of 15 Periods
Data Sources: Bloomberg Barclays; Credit Suisse. Time periods since 6/30/97 when month end 10-year Treasury yields rose at least 50 basis points. Past performance is not indicative of future results.
In addition, because leveraged loans reset on a quarterly basis, they have little duration risk (sensitivity of a bond’s price to a 1% change in interest rates); they are unlikely to see the declines in price that occur with conventional fixed income securities when interest rates rise. Higher payouts, combined with relatively buoyant prices, suggest leveraged loans could outperform other fixed income assets as interest rates climb.
2. LIBOR has risen—and may not reverse
Many investors may not have noticed that this key short-term rate, 3-month LIBOR, has been trending upward. As of November 11, it stood at 0.89%, up from just 0.36% a year ago.
Exhibit 2: 3-Month LIBOR (5-year period ending 11/11/16)
Source: ICE Benchmark Administration Limited (IBA); fred.stlouisfed.org. As of 11/11/16. Data pulled 11/18/16.
While jumps in yield are often a signal of an increase in risk, this one has occurred because of a change in regulations. To enhance stability during periods of market stress, the Securities and Exchange Commission (SEC) amended the rules governing money market funds. These amendments took effect on October 14, 2016, and require the following changes:
- Institutional prime money market funds must allow their net asset value (NAV) to float with market fluctuations rather than maintain a fixed NAV of $1 per share. (Prime money market funds invest in shortterm corporate debt securities. U.S. government money market funds are exempt from the new rules.)
- Both institutional and retail money market funds are now subject to liquidity fees and redemption gates, which are designed to limit outflows, if their liquid assets fall below a certain threshold.
These new rules resulted in significant flows out of prime money market funds and into government funds. Over the past 12 months, $626 billion in assets flowed out of the category (as of 10/31/16; Source: Strategic Insight). In anticipation of further redemptions, prime money market funds shifted into shorter-term debt that matured prior to the October 14 effective date. As a result, demand for 3-month commercial paper fell, and yields on these securities – as represented by LIBOR – rose.
Exhibit 3: Outflows from Prime Funds Have Surged, as Have Inflows to Government Funds
Source: Crane, Goldman Sachs. As of 8/24/16
Some investors in leveraged loans have benefited from LIBOR’s rise. According to data from Credit Suisse, approximately 30% of leveraged loans have either no LIBOR floor or a floor of 0.75%. As a result, the rates on many of those loans have already reset. The remaining 70% of leveraged loans have a LIBOR floor of 1.00% or greater, and many would reset if LIBOR exceeds 1.00%.
And this could happen if redemptions from prime money market funds continue. If redemptions persist into 2017, managers will probably keep shifting into short-term government debt and out of commercial paper in order to maintain liquidity. This, in turn, will keep upward pressure on 3-month LIBOR, and could even push it above 1.00%. Longer term, a diminished investor base could reduce demand for commercial paper and other short-term bank debt, helping sustain 3-month LIBOR at an elevated level.
3. Defaults: lower for longer?
Defaults surged early in 2016, but this was largely a sector-specific event. Companies in the Energy and Metals & Mining sectors accounted for the bulk of these defaults, as declining prices for oil and other commodities pressured their revenues. For leveraged loans generally, the par-weighted default rate was 2.24%, as of September 30, 2016, but with these two sectors excluded it was just 0.83%, according to data from J.P. Morgan.
In 2016, defaults may have peaked in the first quarter (see Exhibit 4), but they reversed with the market rally in the second and third quarters of 2016. In fact, J.P. Morgan believes that the leveraged loan default rate will end 2016 between 1.5% and 2.0%, below its original 3% forecast.
Exhibit 4: Defaults May Have Peaked Earlier in 2016
Source: JPMorgan. As of 9/30/16.
On the issuance side, ultra-low interest rates, which frustrate savers and investors, have been beneficial for corporate fundamentals. Companies have taken advantage of the current environment to refinance existing debt at lower rates, thus improving their financial health by reducing the burden of interest expense.
If the economy continues to muddle along as it has for several years, these fundamentals should remain steady and interest payments should continue to be manageable. Recent data suggests the economy is continuing to chug along. In 3Q16, the economy grew by 2.9%, up from just 0.8% in Q1 and 1.4% in Q2.
4. Retail demand is rebounding and loan issuance has been robust
Demand in 2016 has been driven largely by the collateralized loan obligation (CLO) market, but now, retail investors are also showing interest. Mutual fund flows into leveraged loan mutual funds have been rebounding. In September, flows enjoyed their third straight positive month (see Exhibit 5). One of the reasons retail investors are returning is the search for yield, and that 3-month LIBOR has been rising.
Exhibit 5: Monthly Flows into Loan Mutual Funds Have Improved
Source: EPFR, Goldman Sachs Global Investment Research. As of 9/30/16.
Demand for leveraged loans is recovering, but issuance surged as well, helping to keep valuations from rising further. The supply of new loans jumped in September, with $53 billion coming to market. In fact, September was the most active month in three years, according to Credit Suisse, and brought the year-todate total for 2016 to $226 billion, 8% higher than the same period in 2015.
Exhibit 6: Issuance of Leveraged Loans Surged in September
Source: Credit Suisse, S&P LCD. As of 10/14/16.
There are several factors at work that make leveraged loans an attractive option. Although the pace of interest rate increases by the FOMC is uncertain, it nonetheless appears that rates will be on the rise over the next 12 to 18 months. New regulations have resulted in upward pressure on 3-month LIBOR. This pressure could persist into 2017 and eventually push LIBOR above 1.00%. Demand is on the rise and market technicals also remain relatively favorable. If bond yields and inflationary indicators continue to rise, investors may be able to capitalize on the appeal of leveraged loans.
Bloomberg Barclays U.S. Aggregate Bond Index is a widely recognized index of securities that are SEC registered, taxable, and dollar denominated. The Index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities and asset-backed securities.
Consumer Price Index is a measure that examines the weighted average of prices of a basket of consumer goods and services. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance.
Credit Suisse Leveraged Loan Index is a market-weighted index that tracks the performance of institutional leveraged loans.
Investors cannot invest directly in an index.
A basis point is equal to 0.01%.
Collateralized loan obligation (CLO) is a special purpose vehicle that issues debt and equity for its capital, and purchases bank loans as assets using that capital to provide a steady stream of income and possible capital appreciation.
Coupon is the interest rate stated on a bond when it’s issued.
Duration is a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates, expressed as a number of years.
The assertions contained herein are based on RidgeWorth’s opinion. This information is general and educational in nature and is not intended to be authoritative. All information contained herein is believed to be correct, but accuracy cannot be guaranteed. This information is based on information available at the time, and is subject to change. It is not intended to be, and should not be construed as, investment advice. Investors are advised to consult with their investment professional about their specific financial needs and goals before making any investment decisions.
All investments involve risk. There is no guarantee a specific investment strategy will be successful.
Past performance is not indicative of future results.
Floating rate loans are typically senior and secured, in contrast to other below-investment grade securities. However, there is no guarantee that the value of the collateral will not decline, causing a loan to be substantially unsecured. Loans generally are subject to restrictions on resale. The value of the collateral securing a floating rate loan can decline, be insufficient to meet the obligations of the borrower, or be difficult to liquidate. Participation in certain types of loans may limit the ability of a fund to enforce its rights and may involve assuming additional credit risks.
Bonds offer a relatively stable level of income, although bond prices will fluctuate providing the potential for principal gain or loss. Intermediate-term, higher-quality bonds generally offer less risk than longer-term bonds and a lower rate of return. Generally, a fund’s fixed income securities will decrease in value if interest rates rise and vice versa. Although a fund’s yield may be higher than that of fixed income funds that purchase higher rated securities, the potentially higher yield is a function of the greater risk of that fund’s underlying securities.
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