Since 1992, the floating rate loan market has only had two down calendar years. The first was the global financial crisis in 2008 and the second was the energy crisis in 2015. Subsequent to those years, the market bounced back more than recouping the prior year’s losses. This fairly consistent return profile tends to surprise people as it makes the case for a strategic allocation while many view the asset class as a tactical trade, as evidenced by highly cyclical flows. While we believe floating rate loans can benefit portfolios through a strategic allocation, we acknowledge the current attractive entry point given the disconnect between fundamentals and prices.
Figure 1: Floating rate loans have only been down two calendar years since 1992
Source: Credit Suisse, 1992-2021. Floating Rate Loans represented by the Credit Suisse Leveraged Loan Index. It is not possible to invest directly in an index. Past performance is no guarantee of future results.
For many, the biggest appeal of floating rate loans is the potential to earn higher levels of income as the Fed hikes rates. Since coupons are calculated by adding a fixed spread to a floating reference rate, they move in the same direction as the reference rate, which is closely correlated to the Fed Funds rate1. Given the aggressive nature of Fed rate hikes to combat inflation, floating rate loan coupons have increased dramatically as shown in Figure 2. In our view, the Fed still has some wood to chop in terms of getting inflation under control and will continue hiking rates. Further, we think it is unlikely that the Fed will begin cutting rates right after hiking so there is potentially still room to realize higher yields.
Figure 2: Steep rate hikes have led to increased coupons
Source: FactSet, Credit Suisse, 2004-2022. Floating Rate Loans represented by the Credit Suisse Leveraged Loan Index. It is not possible to invest directly in an index. Past performance is no guarantee of future results.
Due to the widespread expectation of rising rates coupled with investors looking to avoid duration, money flowed into the asset class throughout 2021. Prices were bid up sharply and peaked at 99.1 in early January 2022. As the perfect storm of growth and inflation concerns along with a geopolitical crisis materialized, the loan market proved to be insulated but not immune to the risk-off sentiment. The asset class held up better than most, but by late second quarter the average price fell to 91.8, the lowest level since early 2020. However, like other risk assets, loans rallied during the third quarter and the average price increased back to 95 in August. Currently, the floating rate loan market is outperforming core bonds and high yield by hundreds of basis points year to date, and investment grade corporates and emerging market debt by over 1000 bps as shown in Figure 4.
Figure 3: Average loan price offers attractive entry point YTD
Source: Pitchbook LCD, 8/19/2022. Floating Rate
Loans represented by the Morningstar/LCD Leveraged Loan Index. Average loan price is the average price of the index. It is not possible to invest directly in an index. Past performance is no guarantee of future results.
Figure 4: Loans outperformance
Source: FactSet, 8/19/2022. Loans represented by Morningstar/LSTA Leveraged Loan Index; High yield represented by ICE BofA High Yield Index; Core bonds represented by Bloomberg Barclays Aggregate Bond Index; Investment grade represented by ICE US Corporate Bond Index; Emerging market debt represented by JP Morgan EMBI
During this recent rally, the loan market (as represented by the Morningstar/LSTA Leveraged Loan Index) returned over 4.5% from a starting price of 91.8 between 7/7/22 and 8/16/22. Based on an analysis performed by JP Morgan on historical returns, lower starting dollar prices have led to greater total returns. Historically a price of 95 has averaged mid – high single digit returns on a 9-12 month go forward basis. At starting dollar prices below 96, loans on average have had a positive return after 6 months.
Figure 5: Forward returns by starting price
Source: JP Morgan, as of 5/23/22. Forward returns shown is for JP Morgan Leveraged Loan Index are since 2010. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
Turning to fundamentals, this earning season seemed to have a lot riding on it as many investors were anxious to see what impact inflation would have on profitability. As per Leveraged Commentary & Data, publicly reporting issuers showed healthy operating earnings growth rates as well as lower leverage ratios. Importantly, interest coverage which measures a company’s ability to service debt, remains above pre-COVID levels as shown in Figure 6. Given a default rate of 0.86% and fairly strong Q2 earnings2, we believe the probability of a soft(ish) landing has increased.
Figure 6: High interest coverage reflect ability to service debt
Source: Morgan Stanley Research, Bloomberg, Capital IQ, S&P LCD
Investing in 2022 has certainly been a challenge, particularly as stocks and bonds sold off in tandem for much of the first half of the year. This broad-based sell-off has created pockets of opportunity in fixed income as dollar prices have declined significantly. With respect to loans, what is different this time is typically when the Fed is hiking rates, prices have been much closer to par. As we have demonstrated, this is not the case now. Given the favorable credit backdrop and increasing coupons, the loan market makes a lot of sense for income investors. Add in a price discount that doesn’t match that backdrop – this leads us to believe that floating rate loans remain attractive.
1 The effective federal funds rate (EFFR) is calculated as a volume-weighted median of overnight federal funds transactions reported in the FR 2420 Report of Selected Money Market Rates.
2 Default rate as of 7/31/22, JP Morgan, Default Monitor .
About Risk
Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.
Floating rate funds are generally considered to have speculative characteristics that involve default risk of principal and interest, collateral impairment, non-diversification, borrower industry concentration, and limited liquidity. Liquidity risk may also refer to the risk that the investment may not be able to pay redemption proceeds within the allowable time period because of unusual market conditions, unusually high volume of redemptions, or other reasons. To meet redemption requests, the investment may be forced to sell securities at an unfavorable time and/or under unfavorable conditions. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks. These risks may be greater for emerging markets. Funds that invest in bonds are subject to interest rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, in which the bond issuer may fail to pay interest and principal in a timely manner.
This material represents an assessment of the market environment as of a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular. This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision. The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.
Index definitions
The Credit Suisse Leveraged Loan Index is an unmanaged index that represents tradable, senior-secured, U.S.-dollar-denominated non-investment-grade loans. This index includes $US-denominated leveraged loan market. To qualify, loans must have a Moody’s/S&P rating no higher than Baa1/BB+ or Ba1/BBB+.
S&P/LSTA Leveraged Loan Index is a broad index designed to reflect the performance of U.S. dollar facilities in the leveraged loan market.
JP Morgan Leveraged Loan Index represents the universe of investable, senior secured, U.S. dollar denominated, non-investment grade institutional loans as presented by J.P. Morgan.
ICE BofA U.S. High Yield Index tracks the performance of U.S. dollar-denominated below investment grade corporate debt publicly issued in the U.S. domestic market.
The Bloomberg U.S. Aggregate Bond Index is a broad-based benchmark that measures the Investment Grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities.
The ICE BofA U.S. Corporate Index tracks the performance of U.S. dollar denominated investment grade corporate debt publicly issued in the U.S. domestic market.
JP Morgan EMBI Global Diversified Index tracks the traded market for U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.
Definitions
Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows. Duration is a measure of sensitivity of a bond's or fixed income portfolio's price to changes in interest rates.
Floating rate loans are commercial loans provided by a group of lenders. A loan is first structured, arranged, and administered by one or several commercial or investment banks, known as arrangers. It is then sold (or syndicated) to other banks or institutional investors. Floating rate loans can also be referred to as leveraged loans, bank loans, or senior secured credits.
“New York Life Investments” is both a service mark, and the common trade name, of the investment advisors affiliated with New York Life Insurance Company. Securities are distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.
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