Keeping afloat as rate tides shift
IM TRACY 04-Jul-2019
It’s no surprise that when virtually all risk assets were selling off sharply late last year, the bank loan asset class also experienced heightened volatility. Investors—especially retail investors—seemed inclined to sell first and ask questions later.
Fast forward to today and bank loans (as measured by the S&P/LSTA Leveraged Loan Index¹) have returned approximately 6.6% through the first five months of 2019. Moreover, the yield-to-maturity S&P/LSTA U.S. Leveraged Loan Index was hovering just above 6.0%, as of May 31, 2019, not bad in the prevailing low-rate environment. Perhaps this illustrates that the market has digested all the cross-currents and determined that bank loans still have a role to potentially boost the overall yield profile of a diversified fixed income portfolio.
When the Federal Reserve made its sharp pivot to a more supportive policy late last year, it seemingly convinced investors that they would be somewhat protected by low rates. This quelled volatility and encouraged more risk taking—great for stocks and other risk assets but not without ramifications for fixed income investors. Shorter-term Treasurys and asset-backed securities, which are generally defensive investments, underperformed. Moreover, other shorter-term yield products, including CDs, money market funds, and low-duration funds, have been experiencing falling yields. So while many investors began the year positioning for higher rates, the Fed changed its tune and caught many investors off guard.
So where to from here? That’s what fixed income investors really want to know. For now, Fed funds futures—financial contracts that represent the market opinion of where short-term rates are headed—are pointing lower, but it’s not a done deal. Upcoming Fed moves (if any) are likely to be data dependent, with the biggest unknown being the disposition of U.S.-China trade talks.
In truth, nobody knows for sure, and this is precisely why bank loans may prove invaluable in the current murky rate environment. Rates for leveraged loans adjust with market rates and are normally based on the London Interbank Offered Rate (LIBOR). There is no need for investors to step out and make a large directional bet. Thus, any time it’s unclear where rates are headed, floating rate bank loans might be a good place to play the waiting game. Why not park some capital in a fixed income instrument where yields can be relatively attractive and adjust regularly, thus offering some price stability in a variety of environments? And although bank loans are rated below investment grade, it’s comforting to know that these loans are still secured and considered senior in a company’s capital structure.
There’s another reason for optimism about the leveraged loan market. The leveraged loan default rate declined from an already-low 1.63% in the fourth quarter of 2018 to 0.93% in the first quarter of 2019, the lowest rate in seven years. In light of improving credit metrics, among other reasons, we are constructive on the leveraged loan market. The bank loan asset class has the potential to continue providing investors with comparatively attractive dividends. Moreover, if the Fed funds futures are wrong, or if the Fed decides to pivot again, this asset class should provide bond investors with shelter given its low duration (i.e. interest rate sensitivity) and variable interest rate features.