Just a little turbulence?
JIM TRACY 01-Jun-2020
The longest economic and market expansion in U.S. history ended abruptly in the first quarter, thanks to the sudden appearance of a pandemic that sent much of the world’s population into quarantine. Add in a mutually destructive oil price war between Russia and Saudi Arabia and it’s no surprise that investors became risk averse.
Predictably, higher-yielding sectors of the fixed income market—and especially those rated below investment grade—were eschewed. The bank loan asset class was not spared, with prices dropping approximately 20% from late January to the trough on March 23, as measured by the S&P/LSTA Leveraged Loan Index. Prices have since rebounded (approximately 13% through the first week of May). This bounce reflects both restored confidence (thanks in part to the Fed) and bargain-hunting by institutional investors.
Although the tenor of the bank loan market has improved and select bond prices have recovered, many retail investors continue to have qualms regarding the bank loan asset class. That leads to the question: Are bank loans simply riding out a rough patch, or is something more troubling afoot?
As long-time investors in this marketplace, we believe the current dynamics may be an opportunity for fixed income investors to invest in an asset class at significantly lower prices provided they are willing to tolerate market volatility. We expect the supply and demand imbalance in the loan market to remain challenging, but the price weakness has already invited opportunism. The record-breaking price declines in early March led to record-breaking increases in the last week of March as institutional investors and hedge funds sought to exploit this opportunity.
Yet there are important takeaways for investors. For starters, the price rally has been far more selective than the decline, which was indiscriminate. Buyers have been trying to size up the potential winners and losers and determine how the post-pandemic economy will unfold. Broadly speaking, securities from the healthcare, telecom, cable and packaging industries have rallied, while casinos, hotels, restaurants, and non-food retail have not participated in the rebound thus far. Risks remain and not all parts sectors will recover equally.
For those investors who are committed to the bank loan space long term, it’s worth reiterating that fundamental credit analysis becomes critically important in such an uncertain economic environment. Sector selection and allocation will be drivers of performance in volatile markets, while liquidity and transparency considerations are also paramount.
Despite all the economic turmoil, the bank loan marketplace has been resilient and continues to function despite the record selling and unprecedented volatility of the first quarter. That’s a good sign. It’s also worth noting that at the beginning of this crisis, default rates were very low—less than 2%. We expect defaults to rise through 2021, but an active approach and deep credit analysis, including monitoring every security in the portfolio for items like cash on hand, undrawn revolving credit lines, and debt service capacity, could help manage risk.
Another reality influenced by this pandemic is the fact that many investors still have income needs that simply cannot be fully met by a Treasury-focused fixed income portfolio. Where will they look to capture that incremental yield? For investors able to withstand some volatility, the bank loan asset class may still play a valuable role in a diversified fixed income portfolio.