Boston - With the U.S. economy humming and corporate fundamentals on solid footing, it's perhaps little surprise that markets have been cooperative this year. Investor sentiment remains strong and this has fueled higher-still stock prices, which of course is further supporting positive sentiment. It's a bull market.
On the fixed-income side of portfolios, we see markedly less optimism. Low yields are no fun, and the negative impact of rising policy rates has flattened the yield curve and sent bond prices lower.
Loans a bright spot
Yet, corporate credit sectors have performed well, and senior floating-rate corporate loans have been a bright spot. Year to date, the S&P/LSTA Leveraged Loan Index has returned 4.03% through the first three quarters of 2018, outpacing most bonds by a wide margin. To cite a common bond market proxy, the Bloomberg Barclays Aggregate Index has lost 1.60% over the same period.
Returns, though, are in the rear-view mirror. More important is what's ahead. To that end, we'd offer that coupon income has historically proven to be a reliable forward performance proxy, and for many loan investors that means a base case performance profile of 5-6% today.
The yield on the S&P/LSTA Leveraged Loan Index was 5.76% entering the fourth quarter, and all else equal, this is expected to rise as the Federal Reserve continues on its path to normalize interest rates by lifting short-term rates. That's because loan coupons float over one- or three-month LIBOR (London Interbank Offered Rate), and these historically track closely with the Fed.
We believe the simple math supporting the case for loans is compelling today. They have yields rivaled by few other asset classes, while the absence of bond duration helps to diversify fixed-rate positions. Loans are also at fair value, meaning they are trading near their intrinsic value of par, and with credit spreads right at long-term averages. Finally, loans have the help of a Fed on the move.
Deeper dive on defaults
Despite these tailwinds, lately we have seen articles about the prolonged length of this particular business cycle and that alas, loan defaults will eventually pick up.
There's no denying that the asset class has a certain cyclicality to it, but a deeper dive on the math of defaults is required, we think.
Default rate consensus expectations are grounded in the 2-3% range for the next several years, affording to the positive fundamentals and strong economy noted earlier. Given loans are senior in the capital structure and secured by assets, recoveries in the case of default have averaged 77% over the long run, according to the latest Moody's data.
To put this in the context of a 2.5% default rate, the actual impairment to investor net asset values would be 57 basis points. In other words, the loan investor loses 23% of the 2.5%, which is 0.57%. And of course that's part of the price return. Importantly, investors need to consider the income return also, which as noted above is expected in the 500-600 basis points range.
Recovery rates
What about when defaults rise further? At their peak in the last few recessions the default rate hit 10%, right? Using the same recovery rate, that equals an actual loss given default of 2.3%, which truly is not very scary, particularly when netted against 5-6% of income generation. It's still a positive return in the face of a relatively ugly fundamental picture.
But what if recoveries are lower this time? That's a fair question and it deserves considering. We have seen recent articles pointing out "covenant-lite" loans and "loan-only" structures, both of which have climbed. In its latest report, Moody's estimates that loan recoveries could be as low as 61% looking ahead, 16 percentage points lower than the long-term 77% average.
How would this impact returns if it played out? On a 2.5% default rate, it worsens things by 40 basis points. And on a 10% default rate, that figure is 1.6%. Still very small numbers, both in an absolute sense and certainly in a relative one. Not to mention we think recoveries will be higher than what Moody's suggests is possible. Loan-to-value and other important credit metrics remain in line with the long-term character of the asset class. These are the most important things in our view.
Bottom line: We believe loans and their mid-single-digit return profile are attractive. This may end up rivaling the performance of stocks, while loans also remain an "anti-bond" diversifier in fixed-income portfolios.
Data sources: S&P/LCD, Bloomberg Barclays, as of 9/30/2018.
The S&P/LSTA Leveraged Loan Index is an unmanaged index of the institutional leveraged loan market.
An imbalance in supply and demand in the income market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. The secondary market for loans is a private, unregulated inter-dealer or inter-bank resale market. Purchases and sales of loans are generally subject to contractual restrictions that must be satisfied before a loan can be bought or sold. These restrictions may impede the Fund's ability to buy or sell loans and may negatively impact the transaction price. It may take longer than seven days for transactions in loans to settle. It is unclear whether U.S. federal securities law protections are available to an investment in a loan. In certain circumstances, loans may not be deemed to be securities, and in the event of fraud or misrepresentation by a borrower, lenders may not have the income investments is likely to decline. Bank loans are subject to prepayment risk. Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. Changes in the value of investments entered for hedging purposes may not match those of the position being hedged. No fund is a complete investment program and you may lose money investing in a fund.
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