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With Bank Loans Near Par, Have They Lost Their Value?

10/15/2013

Bank loans proved to be very resilient during this summer’s Treasury volatility and remain a leading fixed income sector for the year, returning 3.53% through September (S&P/LSTA Leveraged Loan Index). Given strong demand, bank loan prices have moved closer to par (face value), yet the loan sector remains attractive, in our view. At current levels, loans still offer healthy risk-adjusted yields in a low default rate environment (under 2%) relative to other corporate credit sectors.

Bank Loans and Rising Rates – A Historical Perspective
Many investors are adding bank loans to their portfolios as a preemptive measure against the impact of a rise in short-term interest rates. Bank loans pay a “floating rate” typically reset every 90 days to the 3-month LIBOR (London Interbank Offered Rate). Thus, in a rising rate environment, the loan coupon rises, thereby reducing interest-rate risk compared to traditional fixed income securities which are interest-rate sensitive.

For perspective on the current loan market valuation, let’s use history as a guide and look at similar rate periods in the past. Figure 1 shows the consistently high correlation between the federal funds rate – the Fed’s overnight bank lending rate – and the 3-month LIBOR since 1986. Over that time, there were two notable periods of rising rates: 1) 1994, when rates rose dramatically with seven hikes (Period 1), and 2) 2004 to 2006, when rates rose gradually with 17 increases (Period 2). For both periods, average loan prices were near par, defaults were low, and spreads over LIBOR were tight (Figure 2), yet the bank loan sector (Credit Suisse Leveraged Loan Index) outperformed the broad fixed income market (Barclays U.S. Aggregate Bond Index) and U.S. government securities (Barclays U.S. Treasury Index).

Figure 1: Federal Funds Effective Rate and 3-Month LIBOR Rates (%), 3/31/1986-9/30/2013
Newfleet 10-15-2013 1.1
Source: Bloomberg. *Arithmetic cumulative returns for 2004-2006. Source: Barclays Live, Credit Suisse Leveraged Loan Index, Bloomberg. Loan Index: Credit Suisse Leveraged Loan Index. Bond Index: Barclays U.S. Aggregate Bond Index. Treasury Index: Barclays U.S. Treasury Index. Past Performance is no guarantee of future results.

Figure 2: Bank Loan Market: Key Characteristics

 

Bank Loan Comparison

Period 1
1994

Period 2
2004-2006

 

YTD 2013*

 

Average Price ($)

 

98.36

 

98.52

 

97.83

 

Average Default Rate (%)

 

   1.45

 

   1.81

 

   1.76

 

Average Spread (basis points)

 

237

 

277

 

393

 

*As of 9/30/13. Sources: S&P LCD, 1998 Leveraged Finance Annual Review, Credit Suisse Leveraged Loan Index. Average default rate is the lagging 12-month default rate by principal amount for the S&P/LSTA Leveraged Loan Index. Past performance is no guarantee of future results.

Summary
While the past cannot predict the future, the loan markets of 1994 and 2004-2006 look very similar to today’s loan market. In actuality, today’s loan market is larger and much more developed, with improved liquidity. Borrowing spreads (the spread over LIBOR) are also more attractive, implying that investors are getting paid more today for taking on credit risk than they did in those earlier periods, even though that means being subject to increased price volatility compared to years past.

We believe the strategic reasons to own bank loans as part of a fixed income portfolio remain intact: an interest rate hedge, collateral through their senior security status, low correlation to other fixed income asset classes, and income.

IMPORTANT RISK CONSIDERATIONS: Debt securities are subject to various risks, the most prominent of which are credit and interest rate risk. The issuer of a security may fail to make payments in a timely manner. Values of debt securities may rise and fall in response to changes in interest rates. This risk may be enhanced with longer-term maturities. There is a greater level of credit risk and price volatility involved with high yield securities than investment grade securities. When a fund leverages its portfolio, the value of its shares may be more volatile and all other risks may be compounded. Certain securities may be difficult to sell at a time and price beneficial to the fund. There may be no ready market for loan participation interests. The fund may have to sell the interests at a substantial discount. Such interests are subject to the credit risk of the underlying corporate borrower.

INDEX DEFINITIONS: S&P/LSTA Leveraged Loan Index is a daily total return index that tracks the current outstanding balance and spread over LIBOR for fully funded term loans representing a broad cross-section of leveraged loans syndicated in the U.S., including dollar-denominated loans to overseas issuers. Credit Suisse Leveraged Loan Index tracks the investable market of the U.S. dollar denominated leveraged loan market. It consists of issues rated “5B” or lower, meaning that the highest rated issues included in this index are Moody’s/S&P ratings of Baa1/BB+ or Ba1/BBB+. All loans are funded term loans with a tenor of at least one year and are made by issuers domiciled in developed countries. Barclays U.S. Aggregate Bond Index measures the U.S. investment grade fixed rate bond market. Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury that have remaining maturities of one year or more. The indexes are unmanaged, their returns do not reflect any fees, expenses, or sales charges, and they are not available for direct investment.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus 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.