This has been quite a year for the floating rate loan asset class – mutual funds and ETFs have taken in over $40bn, fully recouping the $27bn of outflows from 2020. Due to both improving credit conditions and having almost no duration, floating rate loans appreciated almost 5% year-to-date through mid-November. Notably, CCC-rated loans have returned 12.6%, outperforming BBs by almost 10%. Given this massive outperformance, it is important for investors to take a deeper look into lower quality loans, and re-evaluate their risk taking as 2022 nears.
Figure 1: CCC-rated loans have generated double digit returns in 2021 YTD
Source: LCD, 1/1/20 – 11/12/21. Loans represented by the S&P/LSTA Leveraged Loan Index. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Taking a closer look at the impressive performance of CCCs, we see that from the fourth quarter of 2020 through the first quarter of 2021, the average price of CCCs increased by over 12% from 82.4 to 91.5. In the subsequent seven months, prices increased by a mere 1.2% to 92.6. It is important to mention that lower quality loans have relatively high coupons, so loans still generate income regardless of price movements. Still, of the 12.6% in total returns that CCCs have generated year-to-date, 10.0% came in the first half of the year.
Figure 2: CCC loan prices have largely plateaued
Source: S&P Global Market Intelligence, 10/1/20 – 11/12/21. Loans represented by the S&P/LSTA Leveraged Loan Index. It is not possible to invest directly in an index. Past Performance does not guarantee future results.
To get a better sense of historical price levels, Figure 3 shows CCC prices since 2011. During the pandemic, CCCs reached a 10-year low dollar price of 64, and by year end, had already recovered to 87. They have remained rangebound in the 92s since. This is the highest level in six years and 8.5 points above the 10-year average.
Given the current level, CCCs are “priced to perfection” in our view. In fact, there are many COVID sensitive names that are now trading close to par – which leaves plenty of room for downside, with little upside. Investors were well compensated for risk taking from late 2020 through early 2021, but it is critical to evaluate return prospects going forward, and not chase yesterday’s returns.
Figure 3: CCC floating rate loan prices are well above average
Source: S&P Global Market Intelligence, 7/1/11 – 11/12/21. Loans represented by the S&P/LSTA Leveraged Loan Index. It is not possible to invest directly in an index. Past Performance does not guarantee future results.
One way to do this is to look at how CCCs have performed given various starting price levels. We analyzed rolling 1-year returns over the past 20 years segmented by starting price in order to compare performance by rating.
As expected, CCCs outperformed the market at lower dollar prices. However, as CCCs approached 90, they began to underperform the market. At prices greater than 92, the average 1-year forward return of CCCs not only underperforms the market, but is also negative.
Figure 4: At higher dollar prices, CCC floating rate loans averaged negative 1-year returns
Source: Credit Suisse, 6/30/01 - 9/30/21. Loan market is represented by Credit Suisse Leveraged Loan Index. It is not possible to invest directly in an index. Past Performance does not guarantee future results.
Our approach
At New York Life Investments, we believe that aggressively positioned portfolios have underperformed more in times of credit stress, than they outperformed during times of credit prosperity. Therefore, we aim to construct portfolios with a quality bias because they have the potential to result in a less volatile, more attractive return profile.
We entered the loan market in 1994, and currently manage $7.7 billion in floating rate loans for both retail and institutional investors, including the general account of New York Life Insurance Company. Because of this heritage, there is an ingrained conservatism through our entire investment process – from credit analysis of individual loans through building and managing portfolios, and finally continuously monitoring risk in portfolios.
We approach floating rate loans as an income generation strategy rather than having a total return objective. When loans default, they don’t pay interest which adversely impacts a portfolio’s yield. Following restructurings, a portfolio will often receive equity which does not contribute to income and can take years to recover to pre-bankruptcy value. Since CCC’s are much more likely to default than BB-rated loans or even single-B loans, we tend to avoid that part of the market.
Even when CCC prices are depressed, we remain disciplined in our process that consists of in-depth credit analysis, allowing us to underwrite loans in which we have high conviction in the issuer’s long-term prospects.
More aggressive loan funds benefited from the recovery in lower quality from late 2020 through the first half of this year. Over the last couple of months, CCC prices have leveled off and only provided modest price appreciation.
Credit fundamentals are certainly strong, and default rates are expected to remain sub 1% through next year.1 But relative value indicators in the lower quality part of the market are flashing caution.2 Moving forward, we believe a higher quality, less volatile approach to the floating rate loan market has the potential produce a more favorable investment outcome for clients.
- JP Morgan, as of 12/1/21
- S&P Global Market Intelligence, as of 12/6/21. CCC prices have plateaued since the Spring, and have declined more recently.
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.
For more information about MainStay Funds®, call 800-624-6782 for a prospectus or summary prospectus. Investors are asked to consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus or summary prospectus contains this and other information about the investment company. Please read the prospectus carefully before investing.
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.
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.
'More aggressive' funds are those that have a high percent of CCC exposure.
“New York Life Investments” is both a service mark, and the common trade name, of certain 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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