Are Bank Loan Repricings All Priced In?
Amid target Fed Funds Rate increases by the Federal Reserve, investors have flocked to bank loan funds due to their attractive income properties when interest rates rise, and negative correlation to U.S. Treasurys. June 2017 was the twelfth consecutive month of inflows (see exhibit 1, below), for a total of $33 billion.1
Figure One: Demand Is on a Roll
Monthly Loan Flows Positive for a Twelfth-Straight Month in June
Source: JP Morgan. Data as of 7/5/17.
Where once upon a time LIBOR floors had enabled investors to count on at least a minimal spread, floors are no longer relevant as 3-month LIBOR stands at 1.3%2. With LIBOR “through the floor”, the theory is that bank loan investors should earn a higher yield as interest rates rise.
If Bank Loans Reset as Rates Increase, Why Hasn’t the Yield on Bank Loans Increased?
The answer to this has to do with new issuance and repricing, which we explain below. At first glance, gross new issuance is $577 billion through the end of June, the second highest calendar year on record, and would appear to be sufficient to absorb the inflows into the asset class. However, as illustrated in the chart below, 78% of that issuance is for refinancing and repricing purposes, with most of the remainder reserved for leveraged buyout (LBO) and merger & acquisition (M&A) activity.1
With all the inflows into the asset class and favorable credit fundamentals, investors are willing to pay a higher price for loans. Since loans are callable after a short period of call protection, an issuer can reprice the nominal spread to the prevailing rate of interest for that credit risk, at which point, an investor has to choose between accepting a lower nominal spread on their loan, or having their principal returned.
This is where net new issuance becomes important: With limited issuance beyond what is used for repricing/refinancing purposes, it can be difficult to reinvest those proceeds in the primary market. The question for portfolio managers becomes “Do I want to stay in the credit or get out?” Because either way, they may be forced to earn less yield on that asset. So, a theme in the first half of the year has been spread compression somewhat offset by rising LIBOR, resulting in yields to investors being relatively unchanged. Since there is only so much an issuer can reprice, we believe that investors may potentially see increases in bank loan yields if rates continue to increase in the second half of the year.
Figure Two: High Level of Refinancing Drove Spreads Lower in First Half of 2017
Gross New Issuance on Record Pace, Net New Issuance Muted
Source: JP Morgan, chart created by New York Life Investment LLC.
Where Do Bank Loans Go From Here?
With respect to credit fundamentals, at the end of June, JP Morgan reported a 12-month default rate of 1.4%.1 We believe there may be more defaults in energy and retail, but we expect them to be fairly isolated, and in our view, the overall default rate won’t jump significantly. Leverage has ticked up, but interest coverage (the ability for a firm to generate cash flow to service debt) remains strong relative to historical levels. Therefore, by itself, the increase in leverage is not alarming and we feel credit fundamentals remain favorable.
Investor interest in the asset class has continued because rates on the front end of the curve (maturities of one-year or less) are moving higher and are expected to continue in that direction. While there is some uncertainty regarding the tax bill and economic growth and what that means for rates, the market seems to expect at least one more rate hike this year and the economic data, in our opinion, supports that. As bank loan investors, we like rising rates, because the more rates increase, the more likely it is they will stay ahead of repricings, allowing yields to rise. Given where fundamentals are today, the expectation of rising rates, and the slowing down of repricing activity, we believe bank loans can generate attractive levels of income in an asset class that is relatively uncorrelated with equities and U.S. Treasurys.
- Source: JP Morgan Leveraged Loan Monitor, July 5, 2017.
- Wall Street Journal, 6/30/17.
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.
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.
Basis points (BPS) refer to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument
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.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
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 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.
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.
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.
LIBOR floors – The London Interbank Offered Rate (LIBOR) is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. LIBOR floors provide a guaranteed minimum yield on loans no matter how low the benchmark three-month London interbank offered rate fell. Today, most loans offer a 1% LIBOR floor, and the three-month LIBOR rate stands at 0.25%, meaning a loan with a LIBOR floor gives investors a yield base that’s three-quarters of a percentage point higher than a floorless loan (loans vary in terms of how much additional yield, or spread, they offer above either LIBOR or the floor rate).
The 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
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.
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