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Outlook positive for bank loans

05/29/2012

Bloomberg recently reported that investors poured $729 million into U.S. floating rate bank loan funds in April, based on preliminary data from research firm EPFR Global – the largest inflows to the sector in 11 months. The growing interest in bank loans is not surprising, given the current environment of record low interest rates and asymmetric interest rate risk where rates basically have nowhere to go but up. Bank loans appeal to investors searching for yield because of the attributes they offer: attractive yields and relative value, seniority and security in the capital structure, and floating rate coupons. 

Attractive Yields: The S&P/LSTA Loan Index currently provides a 6.15% yield to maturity. Further, the differential between the yield to maturity of loans and bonds is on the tighter end of the historical range, making bank loans attractive relative to high yield bonds.

Seniority and Security: Even though bank loans are considered non-investment grade debt and carry risks, they tend to have lower default rates and better recovery rates compared to traditional fixed-rate high yield bonds. Bank loans’ senior status in the capital structure offers added security, as owners of these bonds have first rights to payment in the event of a loan default. This is important in mitigating downside risk and is a reason why bank loans have exhibited about 65% of the volatility of the high yield sector since 1997.

Floating Rate Coupons: Bank loans pay a floating interest rate tied to a recognized base rate, such as the London Interbank Offered Rate (LIBOR), which is reset every 30, 60, 90, or 180 days, plus a premium (or spread). Bank loans have a negative correlation with U.S. Treasuries, which mitigates interest rate risk. As one of the few fixed income vehicles that have floating rate coupons, bank loans are also helpful with portfolio diversification.

At Newfleet, our outlook for the sector is quite favorable based on strong fundamentals, attractive valuations, and expectations for modest, yet still positive, economic growth over the next six to 12 months. As of May 24, 2012, the average price of bank loans was $93.91, according to the Credit Suisse Leveraged Loan Index – below the historical average price of $97 prior to the peak of the 2008 credit crunch in the second half of that year.

For the time being, bank loan valuations remain attractive, offering good total return opportunities and attractive yield. Even if the bank loan default rate rises modestly as it is expected over the next year, it should remain low and well below the long-term average over the next 12 to 18 months. Loan recovery rates should also remain normalized. The biggest risk to our outlook on the bank loan sector would be a weaker-than-anticipated economic recovery or an exogenous shock. For now, we remain positive on the sector.

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.