Amid Rising Rates and Inflation Fears, Leveraged Loans Shine

Rising 10-year Treasury yields and accompanying inflation fears have roiled fixed income markets in recent weeks. This has caused investors to take a hard look at their core bond allocations – and to ask whether assets that have served them well in the past may no longer be best suited for changing conditions.

Some investors are looking to the leveraged loan market, drawn by its short-duration, floating-rate structure, and other benefits in a low but rising interest rate environment – advantages that look more compelling against the supportive backdrop of a rebounding economy, strong fundamentals, and technical tailwinds. Recent retail flows bear this out: Following $27.8 billion in outflows last year, $13.1 billion re-entered the leveraged loan market in the first quarter of 20211 as investors became more concerned about rising rates.

In an environment where 10-year Treasury rates are rising but short-term Libor is holding steady, leveraged loans may look attractive relative to longer-duration fixed-rate core bonds, which have greater exposure to interest rate risk. That said, careful credit selection will be critical to tap the benefits of the sector while avoiding potential pitfalls, including repricing risk and overleveraged credits amid today’s abundant liquidity.

Rising long-term interest rates highlight benefits of leveraged loans

Loans are floating-rate in nature, and because their base rate, Libor, resets every one to three months, leveraged loans have a short duration. Libor moves in step with the federal funds target rate, and the Federal Reserve has signaled that it may not touch benchmark rates for some time.2 When the short end of the curve does start moving higher, the movement will translate into higher coupons for loans.

This is in contrast with the recent rise in 10-year Treasury rates and expectations for further increases. While we don’t expect the short end of the yield curve to increase materially over the next year, the fact that loans pay a spread over a floating base rate helps protect investors from interest rate risk, especially when compared to long-duration products.

Senior Secured Loans Offer Attractive Features in Rising-Rate Environments

For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the investment manager and are subject to change. ^*Source: S&P/LSTA. Discounted spread to maturity as of 31 March 2021. ^{^}Source: Bloomberg Barclays as of 31 March 2021. ^**Assumes Libor contracts are renewed on a quarterly basis.

Although loan spreads today have tightened significantly from pandemic highs, they're still wide to five-year tights and remain compelling when compared to other fixed income opportunities. Loans are often a beneficiary when long-term rates start moving higher, and we can see how this has played out over the past 15 years when comparing the historical correlations between five- and 10-year Treasuries with different asset classes. As the chart below shows, those in the high-grade categories have a moderate to high positive correlation with Treasuries, while returns for high yield bonds, and even more so for loans, have historically had a negative correlation.

Loans Are Negatively Correlated With 5- and 10-Year Treasuries, Providing Interest-Rate Risk Protection

Fixed income asset class correlation with 5- and 10-year Treasuries (last 15 years ending 31 December 2020)

Source: JPMorgan, S&P/LCD as of 31 December 2020. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the investment manager and are subject to change. MBS is represented by the JP Morgan MBS Bond Index, Aggregate is represented by the Bloomberg Barclays US Aggregate Bond Index, Investment Grade is represented by the JP Morgan US Liquid Index (JULI High-Grade Index), High Yield is represented by the JP Morgan US High Yield Index, and Leveraged Loans is represented by the JP Morgan Leveraged Loan Index.

These attributes significantly mitigate interest rate risk in a rising-rate environment and have contributed to outflows from traditional fixed income and into leveraged loans.

Fiscal stimulus and vaccine optimism are good medicine for loans

When rates are moving up, it's typically on the back of an improving fundamental picture, and loans should benefit from such an environment. We think today is no different: the fundamental outlook is strong, and as the vaccine rollouts continue, economies further reopen, and GDP growth accelerates amid further fiscal and monetary support, loan issuers are well positioned to benefit from the broader economic expansion.

The Biden administration’s $1.9 trillion Covid relief package and massive infrastructure plan stand to benefit the loan markets both directly and indirectly. Direct payments to consumers will boost spending, which is good for restaurants, retail, travel, airlines, and everything down the line, while infrastructure spending will likely boost industries from equipment rental, to housing or construction-related businesses, to distributors of building supplies. While their impact is hard to quantify, both initiatives will hit a multitude of sectors and broadly improve conditions for loan issuers.

As such, we see potential investment opportunity in sectors that depend on the reopening of the economy after Covid disruptions, including cyclicals such as restaurants and travel and leisure, along with certain short-cycle industrials, including those related to fluid power and commercial trucking. Although we don’t believe investors should overreach for yield in this environment, some areas that are still trading at a discount and have the most room for price appreciation – including companies in industries such as airlines that are still being hit hard by Covid – may offer the greatest potential.

Default expectations are falling

Although the loan market hasn't received direct support during the pandemic from the Fed, broader underlying support along with support provided to the high yield market have indirectly afforded greater access to capital for loan issuers. This in turn has influenced the default rate for the loan market: After peaking at 4.17% (by amount outstanding) last September – a level that would likely have been higher without the support of government policies – the trailing-12-month default rate for leveraged loans has since declined to 3.15% and continues to fall.3 Liquidity in the loan market remains ample, and some of the higher-default months of 2020 will fall off the metrics as we move toward the summer months. By the end of the year, we expect defaults to drop to about 2.5% or lower, below historical averages.  

It’s also worth noting that as an investor moves higher in the capital structure, as with leveraged loans, it’s possible to achieve spreads or yields and returns similar to those of high yield bonds, but in a position of greater strength on a risk-adjusted basis. In short, in a default scenario, the senior secured structure of loans can provide better recoveries.

That said, from a credit-rating perspective, the overall loan market is riskier today than it was a year ago, with ratings skewing more toward the single-B category over the past 12 to 18 months. Sixty percent of the market now falls in the single-B category, 4 with the rise attributable more to increased single-B issuance relative to BB and BBB. Notably, CLOs, a key driver of loan demand, tend to favor single-B credits, as we discuss below.

Average Credit Quality for Loans Has Dropped, Making Credit Selection Critical

Leveraged loan credit ratings as % of market value

Source: S&P LCD as of 12 March 2021. Leveraged loan represented by the S&P/LSTA Leveraged Loan Index. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the investment manager and are subject to change.

Robust CLO demand supports a strong technical backdrop

The loan market should also benefit from favorable supply-and-demand technicals. CLOs are the largest driver of demand in the loan market, accounting for 60%-70% of new demand in recent years, with retail and institutional demand accounting for the remainder. With investors turning to floating-rate products, we've seen an increase in demand for CLO debt, and as a result spreads on liabilities have compressed since the start of the year. This dynamic, coupled with loan spreads that generally haven't come in as much as CLO liability costs, has led to an improvement in CLO arbitrage. As a result, we've seen a steady increase in new CLO formation that we expect to continue over the near term.

Improving Arbitrage in CLO Markets Boosts Issuance, Fueling Demand for Loans

Arbitrage (loan nominal spread - CLO debt cost)

Source: S&P/LCD, Intex, Barclays Research as of 1 February 2021. Loan represented by the S&P/LSTA Leveraged Loan Index. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the investment manager and are subject to change.

Within leveraged loans, CLOs tend to favor single-B credits, given caps on the amount of lower-rated assets. Single-B loans provide better spread than their BB and BBB counterparts but still are within the parameters for credit quality. They are also the most prevalent in the market today.

Since flat single-B credits are particularly attractive to CLOs, these credits should benefit from strong technical demand with increased CLO issuance (along with retail inflows). In addition, flat single-B credits offer one of the wider gaps between current spreads and five-year tights, and therefore may have room for further spread tightening.

Some Rating Categories Benefit From Increased CLO Demand, but Credit Selection Is Paramount

Source:  S&P/LCD, KANERAI, Intex, Markit, Barclays Research as of 15 March 2021. CLO data is median across all reinvesting US broadly syndicated CLOs. For illustrative purposes only. We are not soliciting or recommending any action based on this material. Any views represent the opinion of the investment manager and are subject to change.

One factor that could have an impact on the market over the next year or two is the recent update to Moody's weighted average rating factor (WARF) calculation methodology. The updated methodology gives CLO managers more flexibility to invest in lower-rated loans than the older methodology, which was more punitive. With this change, we expect to see increased marginal demand for B3 rated loans, both as new CLOs are issued with the updated methodology and as existing CLOs are refinanced, or reset, and are able to incorporate this new language into their own indentures as well.

In addition to demand from CLO issuers, inflows into retail loan funds and exchange-traded funds (ETFs) have been strong year-to-date. According to S&P, inflows exceeded $13 billion for the first quarter, the highest level in four years. From a supply perspective, first-quarter institutional loan issuance was a record $181 billion; however, refinancings and repayments limited net new supply to an estimated $14 billion (according to S&P as of 31 March 2021). The resulting supply-and-demand dynamics have created a strong technical backdrop for the asset class.

Spreads are still relatively attractive, but repricing risk could change that

Three-year spreads on leveraged loans are around 435 bps above Libor currently5 – relatively attractive levels compared with other fixed income asset classes. However, repricing risk remains a key concern for leveraged loan investors, and we believe spreads could tighten if the trend persists. We observed an acceleration in repricings during the first quarter, with $148.5 billion of the $1.2 trillion loan market repricing, the highest dollar volume of repricings in four years.6 Repricing activity pulled back slightly in March, but 82% of the leveraged loan market is still bid at 98 or better, up from about 78% in January of last year, when we also saw substantial repricing activity. Consequently, we believe future repricing risk remains an issue.

Why the rise in repricings to start the year? With net new primary issuance in short supply and lenders needing to stay fully invested, many have turned to the secondary market, driving up the weighted average bid of the market by 136 basis points over the quarter.7 Because leveraged loans don’t have the call protections that high yield and other fixed rate bonds have, as prices reach par, repricing starts to look attractive to issuers and becomes an omnipresent risk. And given the need to stay fully invested, lenders are generally willing to accept the repricing and take the same loan at a lower nominal spread.

A trend toward looser documentation bears watching

An environment where repricing risk is a concern also creates conditions in which lenders have less leverage when it comes to documentation and protections within credit agreements. As long as technicals remain strong for loans, we’ll likely see a continuation of borrower-friendly language within documentation. We’re seeing issuers succeed with putting forth more aggressive deals with higher leverage given the high demand. In this way, near-term technicals may create a longer-term issue. While looser and more borrower-friendly terms probably won’t have a near term impact on loans, it’s a trend worth watching down the road, when the economy turns negative again.

In seeking alpha, beware the ‘walking dead’

Over-leveraged companies have been able to find liquidity over the past year, creating credits that are essentially just limping along until they eventually need to address their capital structures. The growing prevalence of these “zombie credits” – loans from companies with questionable cash flow and high debt that are being kept alive by easy liquidity – underscores the need for active credit selection to alleviate those risks. Skilled managers that can avoid issuers at risk of default or restructuring while selecting healthier credits with stronger fundamentals are best positioned to create alpha. Indeed, while last year there was a considerable beta opportunity in leveraged loans, conditions have taken a sharp turn to an alpha-driven market where assets are trading tightly and credit selection will determine performance.

Leveraged loans remain a compelling option

As a risk asset class, leveraged loans stand to benefit from the economic rebound from Covid and should continue to perform well as GDP growth picks up, unemployment numbers fall, and confidence continues to build. Leveraged loans can serve as a hedge against rising rates and inflation, which is fueling strong technicals and boosting demand.

While repricing risk remains a concern, we believe the potential benefits will continue to draw investors to the asset class. We continue to see opportunities in sectors that depend on the reopening of the economy after Covid disruptions. These include business lines that are still being hit hard and may be trading at a discount, which have the most room for price appreciation.

All told, we believe loans look attractive relative to other opportunity sets and will remain an option for those looking beyond core allocations for alpha.