Bank Loan Market Update
Recent weakness in the bank loan market appears to be driven by technical and not fundamental issues. In fact, conditions are reminiscent of last year when similar volatility in June and August proved to be short lived. Improving U.S. economic growth and the increased prospect for the Fed to take action and raise interest rates (which have already rallied 60 bps this year) keeps our conviction in bank loans intact.
Following a good second quarter, July started out fine for the leveraged loan market but weakened toward the end of the month and into early August. Performance of leveraged loans, as measured by the S&P/LSTA Leveraged Loan Index, was down marginally at 0.03% in July, and down 0.19% in August (as of 8/8/14). However, loans exhibited lower volatility and performed well relative to high yield bonds, as measured by the JPM U.S. High Yield Index, which were down 1.3% in July, and 0.24% in August (as of 8/8/14).
The high yield bond market has experienced outflows due to tight valuations, rising geopolitical risk, and a stronger Q2 U.S. GDP print that renewed fears of the Fed taking action sooner than expected and raising rates. Retail high yield funds saw roughly $17 billion in outflows over the last 22 days, including a record $8 billion in outflows last week, although daily outflows appear to be subsiding. This heavy selling of high yield has put pressure on the loan market.
We are also seeing some technical pressure within the loan market due to an increased new issuance calendar. Two very large deals (Charter and Albertsons for a total of $11 billion) have come into the market during the slower summer months when institutional investor demand for loans is not typically as strong. Retail bank loan fund outflows have also ticked up a bit but we continue to see institutional demand replace retail interest. In our view, technicals within the loan space are creating attractive buying opportunities for selective investors.
Bank loan market fundamentals remain strong. Specifically, we are seeing solid earnings so far in the second quarter, better U.S. economic growth, and a termed out maturity structure with only 4% of the loan market coming due before 2017.
Loan defaults declined in July to 3.9% (0.62% excluding TXU Corp.) from 4.4% in June. The outlook for credit is benign over the next 18 months with only a modest rise in defaults expected. Defaults (excluding TXU) are expected to remain below the long-term average absent any outside shock over the next 18 months.
Given expectations for GDP growth to improve and interest rates to rise, we remain constructive on the bank loan asset class. The investment thesis remains intact. Loans offer a natural hedge against rising rates, their yields remain attractive compared to other fixed income sectors, and as senior secured obligations in a company’s capital structure, loans offer collateral and credit protection advantages compared to high yield bonds.