PMC Weekly Review - September 14, 2018
Bank loans are having something of a moment in the sun, or about as close as an obscure asset class can get to one. Earlier this year, the size of the market for these floating rate loans, a form of credit to low-quality issuers, rose to more than $1 trillion. Estimates of the market’s size vary, with Fitch Ratings claiming that bank loans reached $1.22 trillion at the end of July, and surpassed the high yield bond market’s $1.21 trillion in face value outstanding. As with any large figure, there is some uncertainty, but what seems clear is that bank loans are now in the same league as high yield bonds and, for the past year, have been the preferred financing method among low-quality issuers. Considering the increasing prominence of bank loans, what should investors know about the asset class?
Most significantly, these loans have a floating rate coupon, which comprises the three-month USD London Interbank Offered Rate (LIBOR)—or one of its alternatives—plus a fixed spread. As benchmark rates fluctuate, so does the coupon investors receive. Obviously, bank loans are not the best asset to hold if investors think interest rates are going to fall over the holding period, but are a much more attractive holding proposition if they expect interest rates to rise, as most market participants currently do. Other notable features include seniority in the capital structure, which places loans above (generally) unsecured bonds, and explicit ties to assets of the issuing firm. Of all the ways to access high yield corporate credit, bank loans look pretty attractive.
Considering these characteristics, it is fairly clear from an investor’s perspective why bank loans are attractive, particularly in the United States’ current economic environment. Why, though, would issuers rely so heavily on debt that is all but guaranteed to result in higher financing costs in the near term? Recently, CFOs have found the loan format, in which issuers expose themselves to interest rate risk, but gain the ability to call a loan at any time without penalty, more attractive than high yield bonds, which lock in interest rates, but generally preclude pre-payment for half of the life of the bond. This continuous callability is a key issuer option that induces firms to choose freely to expose their balance sheets to rising rates, rather than locking them in with fixed rate bonds. Additionally, covenants, which ensure that issuers maintain certain debt-to-earnings or interest-coverage metrics, have eroded over the past ten years, with “covenant-lite” loans rising from less than 20% of the market in 2008 to nearly 80% in 2018, according to S&P LCD. Together, low interest rates and issuer-friendly covenant packages mean private equity firms financing buyouts and many ordinary issuers are likely focusing more on the flexibility that loans afford than the interest they pay on them.
Some issuers have found the loan market so appealing that loans are their only source of financing. UBS estimates that roughly 40% of issuers in the market are loan-only, with that number rising to more than half for B- and CCC-rated firms. According to JP Morgan data, loan-only issuers have accounted for more than half of the market’s issuance since August 2017. This development, in conjunction with the majority of the market being covenant-lite, reflects a market profile that is in the process of shifting lower in credit quality. Senior security is great, unless there is no junior partner, either bond holders or equity investors, to absorb losses when they inevitably materialize. The average recovery rate for first-lien loans going back to 1990 is 67.4%, according to JP Morgan and S&P LCD. Recoveries from 2015 onward have fallen below the average, which should concern investors if defaults rise from the tame 2% trailing 12-month, asset-weighted default rate through July.
For now though, bank loans are doing what they are expected to do by providing investors with respectable returns even as interest rates have risen. In 2018 through mid-September, the S&P/LSTA Leveraged Loan Index has returned more than 3%, compared with slightly more than 2% for the Bloomberg Barclays US High Yield Corporate Index, according to Morningstar. Though it is not equity-like by any means, this sort of performance is quite attractive compared with most other major fixed income sectors. Municipal bonds, investment grade corporate credit, and emerging markets debt, for example, are all in the red year to date. Fundamentals seem solid enough, as issuers’ cash flow coverage ratio remains above three, which is higher than at any time prior to the 2008 Financial Crisis and among the high readings in the post-crisis period. Another positive mark for the asset class is the dominance of refinancing activity over issuance from leveraged buyouts (LBOs), but LBOs as a share of deals are already higher than in 2016-2017, and are pushing average leverage higher.
Considering this information, how should the informed investor approach the asset class? Actively. While passive exchange-traded funds (ETFs) are cheap, this is not the asset class where investors should try to save on their investment management costs. The market’s many idiosyncrasies mean that it is not very difficult to beat the market. The largest ETF in the space, a passive vehicle and proxy for the broad market, has underperformed more than 80% of active mutual fund peers over the trailing five years. Given the growing prevalence of loan-only issuance, especially in the market’s lower-credit-quality tiers, a passive indexing approach will likely result in worse performance than successful active peers the next time sentiment goes south. Bank loans are great instruments to get low-quality credit exposure and potentially avoid losses due to rising rates, but the opacity of the market and the complexities lurking just below the surface necessitate an active and experienced approach if investors hope to reap the full benefits of exposure to the market.