Capital Structure Seniority with a Side of Lower Volatility
Late last year, three-month LIBOR surpassed 1%, making LIBOR floors a thing of the past.
Over the last few years, loans were issued with LIBOR floors—effectively stopping floating rate loans from floating until LIBOR reached a certain level. That level was 0.75% for BB-rated loans and 1.00% for B-rated loans. Now that LIBOR is “through the floor,” coupons on floating rate securities will adjust accordingly with increases in LIBOR as the loans reset, providing investors with higher income.
Floating rate loans reset quarterly, and have little interest-rate risk and a near-zero duration. With economists predicting Fed rate increases for the balance of 2017, bank loans may be a good way for investors to help protect themselves from rising rates. Additionally, default rates ended 2016 at half their historical average (1.5% vs. 3%, JP Morgan, 12/31/16), indicating that credit fundamentals remain favorable.
As you can see in Figure One, flows into the asset class accelerated over the back half of the year. For the full year 2016, loan funds reported $7 billion in inflows, compared with $22 billion of outflows in 2015.
Figure One: Monthly Loan Fund Flows Were Positive for an Eighth Consecutive Month in February
Source: Lipper FMI, as of 2/28/17.
In general, investors looking for more risk can invest in high-yield bonds, and those more interested in seniority in the capital structure and lower volatility can look to bank loans. It doesn’t need to be an “either/or” proposition, but instead, a question of asset allocation.
High-yield bonds have historically performed well during rising rate environments. While we’re not suggesting reallocating entirely from high yield to bank loans, Figure Two shows that the spread between bank loans and high-yield bonds has tightened considerably. In 2016, an investor was able to invest lower in the capital structure and earn an additional 800 bps of total return, relative to bank loans. Today, the spreads between the two asset classes are much tighter, implying an investor may not be able to earn the same additional return for the incremental credit risk. Against this backdrop, on a relative-value basis, bank loans may look more compelling. In other words, an investor may benefit on a risk-adjusted basis by reallocating a portion of their high-yield position into bank loans.
Figure Two: Spread between High-Yield Bonds and Leveraged Loans
Sources: JP Morgan, Markit, as of 2/28/17. Note: Loan yields are to maturity prior to 2011.
The question does arise: How can floating rate loans be compelling if 74% of the market is trading above par? The answer is a bit of a loaded question: Who’s expecting 2017 to look exactly like 2016? At the beginning of 2016, loan prices were depressed, largely due to weakness in energy prices. While there is not the same opportunity for capital appreciation as there was a year ago, we’re still in a benign default rate environment, and there is increased income potential, as short-term rates rise.
Hold the Uncompensated Risk
Figure Three shows how spreads between B- and CCC-rated loans have plummeted. The tightening of relative credit spreads, coupled with a higher average price, underscores the fact that there is simply less reward potential available in exchange for taking incremental credit risk.
In a high average-priced environment, investors need to be patient to find opportunities with favorable risk/return profiles. This is also an advantage over ETFs, which have to trade whenever money comes in (and ETFs have taken in significant bank loan assets). They don’t have the luxury of taking time to locate opportunities the way a conservative, experienced management team can.
Figure Three: Spread between Loans Rated Split-B/CCC & B
Sources: JP Morgan, Markit, as of 2/28/17.
Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.
Bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner.
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.
High-yield securities (junk bonds) have speculative characteristics and present a greater risk of loss than higher-quality debt securities. These securities can also be subject to greater price volatility.
High-yield bonds are represented by the JP Morgan U.S. High Yield Index, which is designed to mirror the investable universe of the U.S. high-yield corporate debt market, including issues of U.S.- and Canadian-domiciled issuers.
Bank loans are represented by the JP Morgan Leveraged Loan Index, which tracks the performance of U.S. dollar-denominated senior floating rate bank loans.
Credit ratings agencies, such as Moody’s, Standard & Poor’s, and Fitch Ratings, have letter designations (such as AAA, B, CC) which represent the quality of a bond. Moody’s assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C, with WR and NR as withdrawn and not rated. Standard & Poor’s and Fitch assign bond credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, and D.
The London Interbank Offered Rate (LIBOR) is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. It is a primary benchmark for short-term interest rates around the world.
MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services.
NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.