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Home / Market Insights / More Than A Rate Hedge – The Overlooked Return Potential of Bank Loans in a Yield Starved Environment

It appears that retail investors (rightly or wrongly) have, over time, conditioned themselves to manage loan exposure relative to their interest rate view, rather than incorporating other major protections—seniority and security—especially at a time of increasing credit or late-cycle scrutiny. Over time, taken in aggregate, these major loan market differentiators have produced attractive risk-adjusted returns relative to other income alternatives. Specifically, these returns have been historically generated through income. To be clear, the loan market is an income asset class, not solely an interest rate hedging tool. It is also relatively attractive to other spread, income-producing asset classes, namely its cousin, the high yield market.

Let's start with the global landscape. It is well documented that global central banks have continued (and in some cases accelerated) accommodative policy measures. Federal Reserve (Fed) Fund Futures point to the U.S. Federal Reserve also pivoting to a more dovish stance with expectations of an interest rate cut at the end of July.

Global negative yielding debt is at a record.

Exhibit 1:  Bloomberg Barclays Global Aggregate Negative Yielding Debt

Bloomberg Barclays Global Aggregate Negative Yielding Debt

Past performance is no guarantee of future results
Source: Bloomberg

The entire Swiss yield curve is negative.

Exhibit 2: Swiss Franc (CHF) Yield Curve

Swiss Franc (CHF) Yield Curve

Past performance is no guarantee of future results. 
Source: Bloomberg

There is even nearly $1 trillion of global negative yielding corporate debt.

Exhibit 3: Bloomberg Barclays Global Aggregate Negative Yielding Debt: Corporates

Bloomberg Barclays Global Aggregate Negative Yielding Debt: Corporates

Past performance is no guarantee of future results.
Source: Bloomberg

Given the aging demographic and ballast that bonds provide an overall investment portfolio, investors are increasingly finding it difficult to generate adequate risk-adjusted income.

The loan market, in my view, should be receiving serious consideration in this regard. However, retail investors are not looking past the “interest rate hedge” tool. Some data might help. We have mentioned in the past that there is a high correlation between interest rate moves and retail fund flows. The charts below illustrate this.

As the 10-year U.S. Treasury yield increased going into 2017 and the first nine months of 2018, we experienced positive retail loan inflows. Coincidentally, the high yield market saw redemptions during this same period. With the start of the dislocation in 4Q18 and Fed pivot to a more dovish stance, the 10-year declined from a high of 3.2% in mid-October 2018 to 2.06% today. The decline in rates, and possible Fed policy shift to interest rate cuts, resulted in over 35 straight weeks of retail loan outflows. Again, during this period, investors moved into the high yield market since interest rate (or duration) risk is now less of a factor.

Exhibit 4: 10-Year U.S. Treasury Yield

10-Year U.S. Treasury Yield

Past performance is no guarantee of future results.
Source: Bloomberg

Exhibit 5: Leveraged Loan Mutual Fund Flows

Image: Leveraged Loan Mutual Fund Flows

Past performance is no guarantee of future results.
Source: J.P. Morgan; Lipper FMI

Exhibit 6: High Yield Mutual Fund Flows

Image: High Yield Mutual Fund Flows

Past performance is no guarantee of future results.
Source: J.P. Morgan; Lipper FMI

This shift from loans into high yield has resulted in loans (blue line, exhibit 7) currently providing more yield (yield-to-maturity) than the high yield market (red line, exhibit 7) as demand for high yield has significantly tightened spreads. Today there is an income advantage in loans relative to high yield, but retail investor flows are not reflecting it.

Exhibit 7: YTM – Loans vs. Bonds

Image: YTM – Loans vs. Bonds

Past Performance is not indicative of future results.
Source: LCD, an offering of S&P Global Market Intelligence

Exhibit 8: Yield Advantage of High Yield Bonds vs. Senior Loans

Image: Yield Advantage of High Yield Bonds vs. Senior Loans

Past performance is not indicative of future results.
Source: S&P Capital IQ and Bloomberg, since inception of the S&P/LSTA Leveraged Loan Index, 1/1/1997, through 6/30/2019

Interestingly, look no further than loan prices to demonstrate what I call “interest rate” investment decisions, rather than income related allocations. The possibility of interest rate hikes in 2013 (taper tantrum) saw inflows, although 71% of the market was 100 or higher. Risk-off periods in 2014 and 2015 experienced outflows despite a market that screened historically cheap (1-3% of the market at 100 or higher). A rising rate environment in 2016 and 2017 generated demand and inflows, but again, the majority of the market was priced well above historic averages. The same was true for much of 2018 until the dislocation in 4Q18 created a rare total return buying opportunity in loans, and we published our thoughts on this at that time. Having said that, from September 2018 thru 2019, market outflows have continued, while the market shows the percentage loans priced par or higher being less than the 2016-17 time period, as well as materially less than the 20-year average.

Exhibit 9: Historical Loan Price Distribution

Image: Historical Loan Price Distribution

Source: LCD, an offering of S&P Global Market Intelligence

Institutional loan investors have been taking advantage of these dynamics, making long-term income-related decisions as it relates to investing in loans, rather than solely on the direction of rates.

Exhibit 10: CLO Volume

Image: CLO Volume

Source: LCD, and offering of S&P Global Market Intelligence

To conclude, the loan market should be viewed more broadly as an income product that has three major differentiators – floating rate, seniority, and security. Taken together, these characteristics have produced attractive long-term, risk-adjusted, income-focused outcomes for investors. The table below illustrates the return per unit of risk for various asset classes. Since 1997, the loan market has outperformed—on a risk adjusted basis—the high yield market, treasuries, and even equities. It is our view that despite the current interest rate environment, loans should continue to be part of an investor’s fixed income allocation as they search for yield in a thoughtful, prudent manner.

Exhibit 11:  Return per Unit of Risk

Image: Return per Unit of Risk

Past performance is not indicative of future results.
February 1997 – July 2019. Source: LCD, and offering of S&P Global Market Intelligence

IMPORTANT RISK CONSIDERATIONS: Credit & Interest: Debt securities are subject to various risks, the most prominent of which are credit and interest rate risk. The issuer of a debt security may fail to make interest and/or principal payments. Values of debt securities may rise or fall in response to changes in interest rates, and this risk may be enhanced with longer-term maturities. Bank Loans: Loans may be unsecured or not fully collateralized, may be subject to restrictions on resale and/or trade infrequently on the secondary market. Loans can carry significant credit and call risk, can be difficult to value and have longer settlement times than other investments, which can make loans relatively illiquid at times. High Yield-High Risk Fixed Income Securities: There is a greater level of credit risk and price volatility involved with high yield securities than investment grade securities. Leverage: When a fund leverages its portfolio, the value of its shares may be more volatile and all other risks may be compounded. Liquidity: Certain securities may be difficult to sell at a time and price beneficial to the fund.

Bloomberg Barclays U.S. Treasury Index measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting.

The BofA Merrill Lynch 10+ Year U.S. Treasury Index is a subset of the BofA Merrill Lynch U.S. Treasury Index, including all securities with a remaining term to final maturity greater than or equal to 10 years.

The ICE BofAML U.S. High Yield Index tracks the performance of U.S. dollar-denominated below investment grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below investment grade rating. Original issue zero coupon bonds, 144a securities, both with and without registration rights, and pay-in-kind securities, including toggle notes, qualify for inclusion. Eurodollar bonds, taxable and tax-exempt U.S. municipal, warrant-bearing, DRD-eligible and defaulted securities are excluded from the Index.

The S&P/LSTA Leveraged Loan Index is a daily total return index that uses LSTA/ LPC Mark-to-Market Pricing to calculate market value change. On a real-time basis, the index tracks the current outstanding balance and spread over LIBOR for fully funded term loans. The facilities included in the Index represent a broad cross section of leveraged loans syndicated in the United States, including dollar-denominated loans to overseas issuers.

The S&P 500® Index is a free-float market-capitalization weighted index of 500 of the largest U.S. companies. The index is calculated on a total return basis with dividends reinvested.

Collateralized loan obligation (CLO) is a security consisting of a pool of loans organized by maturity and risk.

Return per Unit of Risk is the annualized return divided by the standard deviation.

Standard Deviation measures variability of returns around the average return for an investment portfolio. Higher standard deviation suggests greater risk.

Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held until it matures.

This commentary is the opinion of Newfleet Asset Management. Newfleet provides this communication as a matter of general information. Portfolio managers at Newfleet make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.

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