With loan and bond yields currently comparable, we believe—in a somewhat contrarian view to the market—there is a good argument for investing in loans, particularly in the U.S., where the economy appears to be marginally stronger than in Europe.
Interest rate expectations have gone down materially this year, contributing to a notable shift in investor sentiment and material outflows from loan retail funds. This isn’t altogether unexpected—when interest rates were on the rise, investors flocked to loans due partly to their floating rate coupon and potential to offer protection in a rising rate environment. In the last several months, as the U.S. Federal Reserve has turned increasingly dovish, the reverse has happened, with investors eager to shift into fixed rate assets.
But when it comes to investing in high yield, it’s not as simple as ‘when rates rise, buy loans; when rates fall, buy bonds.’
As we look across the high yield markets today, despite concerns over slowing economic growth and the creditworthiness of some high yield issuers, corporate fundamentals appear stable, and we believe most companies have capital structures in place that can withstand and adjust to a slowdown. Outside of select industry sectors that continue to face headwinds, overall default rates are below 2% and expected to remain at those levels in the near-term.
Nonetheless, the recent sentiment-driven shift from loans to bonds has resulted in the yield differential between the two asset classes reaching its lowest level in the last 10 years. With loan and bond yields currently comparable, we believe—in a somewhat contrarian view to what’s happening in the market—there is a good argument for investing in loans, particularly in the U.S., where the economy appears to be marginally stronger than in Europe.
LOAN AND BOND YIELDS ARE CURRENTLY COMPARABLE
SOURCE: J.P. MORGAN. AS OF July 31, 2019.
Because loans are senior in priority to other outstanding debt in an issuer’s capital structure, loan holders typically get paid back ahead of other creditors. Loans are also secured by some or all of a borrower’s assets, which provides additional credit risk protection as secured loans typically have first-priority claim on a borrower’s assets in the event of default. Given this security, loans have historically offered high recovery rates relative to other asset classes. As of February 2019, the long-term average recovery rate for senior secured loans was just over 80%.1 In addition, loans have historically exhibited low volatility compared with other asset classes, which in the context of a broadly diversified portfolio, can reduce the portfolio’s volatility and increase its long-term risk-adjusted return potential.
LOANS HAVE EXHIBITED LOWER VOLATILITY OVER TIME
SOURCE: CREDIT SUISSE; BLOOMBERG BARCLAYS; S&P 500. AS OF JULY 31, 2019.
This type of opportunity is not uncommon—the high yield markets have historically been punctuated with periods of dislocation, during which technical factors have caused any one segment to outperform or underperform for a period of time.
As it can be very difficult to time investment decisions around these movements, we think there are benefits to considering a strategic allocation to high yield. One way to do this is through a multi-credit strategy that invests in bonds and loans across both the U.S. and Europe. In addition to providing managers with the flexibility to pivot to the regions or sub-asset classes they believe offer the best relative value at any given time, this type of strategy can allow managers to move away from areas that are not providing adequate compensation for risks.
A multi-credit strategy can also give investors exposure to non-traditional segments of the market on an opportunistic basis. As we mention in our recent episode of Streaming Income, we believe some of the most attractive late-cycle value sits beyond the index, in areas like collateralized loan obligations (CLOs), distressed debt/special situations and emerging markets debt. In this continued slow growth, low-rate environment, investors can potentially earn incremental yield by intentionally taking credit risk in these less trafficked asset classes—but doing so in a strategic, risk-controlled way is critically important. While these markets function somewhat differently than traditional high yield markets, and they’re not represented in the indexes, they can offer attractive opportunities, particularly for managers with the right expertise.
1 Source: Moody’s Corporate Default & Recovery Rates. As of February 2019.