By Christopher Remington
With all eyes in the fixed income market on the US Federal Reserve (the Fed), which is clearly inching closer to its first policy-rate increase in nine years, investors need to be asking what asset classes are best suited to this environment. Floating-rate loans (FRLs) should be near the top of any list, as they’re a seemingly “win-win” for investors in every scenario.
Consider the following:
If the Fed moves as expected, the coupon interest payments on loans increase (after approximately the first 75 basis points, a limited delay resulting from LIBOR floors that are on average set around 1%). Since loan coupon payments float with short-term rates, a Fed on the move means higher income for investors.
If the Fed delays its first rate hike, investors enjoy being “paid to wait” because FRLs offer a yield of 5.3%, as of 30 June (based on the S&P/LSTA Leveraged Loan Index) – a yield advantage over most other bond sectors.
If rates rise along the Treasury curve (as they have for much of 2015 so far), investors may be insulated by owning something that typically doesn’t go down when rates rise. FRLs have bond duration that’s near-zero, resulting in limited correlation with rates and thus a performance buffer relative to traditional bond segments.
If the Fed moves too fast and kicks the US economy into recession (as unlikely as that may be), loans may outperform other risk assets like high yield bonds and equities. FRLs are unique in that they are senior in the issuer’s capital structure and usually secured by specific assets.
Through 30 June, the 2.8% year-to-date total return on FRLs (based on the S&P/LSTA Leveraged Loan Index) has been the strongest among US fixed-income sectors. We believe the asset class has benefited from a number of positive factors:
Strong fundamentals:
Cash flow coverage is high – At 4.2x, cash flow coverage of interest – the ability of FRL issuers to service their debt – is at its highest level in 10 years, over which it has averaged 3.2x, as of 31 March.
Leverage has fallen – At 5.9x EBITDA, total leverage is down from its recent peak of 6.9x in the third quarter of 2012, and comparable to its 10-year average of 6.1x, as of 31 March.
Defaults are way down – For the trailing 12 months as of 30 June, the default rate, measured by par outstanding, was just 1.2% – substantially below the 10-year average of 2.6%.
Attractive valuations:
Strong yield – Among US fixed income sectors, the 5.3% yield on the S&P/LSTA Leveraged Loan Index, as of 30 June, is second only to high yield.
Spreads are wider than average – At 496 basis points (bps) above Libor as of 30 June, the spread of the S&P/LSTA index is wider than the 10-year average of 484bps. From a longer-term perspective, loans today offer substantially better value than the pre-financial crisis market, in which spreads averaged 347bps above Libor from 2000 to 2007.
FRLs pulled back a bit in June – the first monthly setback of the year, largely due to technical factors and events in Greece. We believe that this weakness is temporary and that it presents an opportunity for investors considering the asset class – the softening of prices may provide an attractive window to establish or add to FRL positions.
With roundly $1trn outstanding globally, FRLs represent a significant corporate debt asset class, comprising an issuer base that includes some of the largest companies in the US, Europe and beyond. We believe that an allocation to a diversified portfolio of loans offers an attractive complement to other fixed income investments that may be more vulnerable during periods of rising rates – like the one that may be just around the corner.
Christopher Remington is director of institutional portfolio management at Eaton Vance
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