Some investors say it’s too late in the business cycle to enter bank loans. What is your view?
We believe we are currently in the late expansionary phase of the credit cycle – not end of cycle and certainly not in the downturn. Growth in the US is currently 2%–2.5%. Slow, predictable growth is typically good for bank loans. We maintain a healthy view of corporate fundamentals and continue to think it is a good time to be lending to corporate America. Additionally, with a 3-year average life, bank loans have a short-term investment horizon.
Why should investors consider adding a bank loan component to portfolios?
I think there are several reasons. First off, given the overall low yield environment, bank loans currently offer meaningful yield pickup over many other debt sectors. Second, they can provide corporate credit exposure with less interest rate sensitivity in a rising rate environment. Third, bank loans are typically made to companies with below investment grade ratings, yet they are senior in the capital structure, secured by the company’s assets, providing additional security in a potential credit downturn. Finally, bank loans have historically had a low correlation to traditional fixed income and equity markets and may help diversify sources of portfolio risk.
Can you discuss default risk in the bank loan market?
Default risk is almost entirely related to principal repayment, since interest payments are usually small in size. Therefore, we pay close attention to the maturity schedule in the bank loan market. With less than $35 billion coming due before the end of 2020, default rates are likely to stay below their long-term historical average rate of 2.5%. If a default were to occur, bank loans typically recover 70 to 80 cents on the dollar, 20 to 50 cents more than the average high yield bond recovery rate.
What’s currently more attractive to the team, the bank loans or high yield market?
We still prefer bank loans over high yield bonds. Even with the market swoon in late 2018, we’re not seeing a lot of opportunities in the shorter-duration portion of the high yield space. Our global asset allocation team forecasted slightly higher returns in the bank loan market versus high yield for the next 12 months. So we don’t think the yields are compelling enough to be junior in the capital structure and unsecured.
How might the Federal Reserve’s interest rate policy impact bank loans?
Our macro team is forecasting one hike later in 2019 and one for 2020. Rate increases are positive for the bank loan asset class, as loans are floating-rate, and coupons will increase as rates rise, while prices would be unchanged. While it’s hard to predict how much refinancing we’ll see in 2019, we only expect a portion of each rate increase to be passed along to our investors, as companies will continue to refinance where they can and lower the spreads offered above LIBOR. It’s also important to note that there’s typically a lag before we see coupons increase, due to the nature of the three-month interest billing cycle.
Can you talk about covenant-lite loan issuance and its effects on the market?
Covenant-lite loans, a term that typically refers to the lack of one financial maintanence covenant, continue to be the most talked about topic in the bank loans market. There are a lot of misconceptions around covenant-lite loans, which make up 80% of the overall loan market. In our new report, Loomis on Loans, we’re encouraging loan investors to look past this overly simplistic label. Of course, there are loans with better and worse covenant packages over every credit cycle, and we detail some of the specific covenants that we track in Loomis on Loans.
What risks are you keeping an eye on?
Retail and healthcare are a focus. We evaluate companies in these sectors one by one to see which will be resilient as these industries undergo change. In terms of the regulatory environment, there are no causes for concern that could disrupt the market on the horizon right now. This is unlike the environment we saw in early 2016, with CLO risk retention being enforced in the market (this has since been overturned). Finally, we’re always on the lookout for another risk-off trade – which we think would likely be motivated by geopolitical events – and hope that it would provide some buying opportunities.
Finally, how might bank loans act as a portfolio diversifier?
As I mentioned previously, bank loans are more than a floating rate instrument. They are another form of credit investing and could provide some credit benefit as we enter a late phase of the credit cycle.
All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed-income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.
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