Popularity of tradable bank loans takes a hit as interest rates rise
Leading the list of things popular in the world of fixed income over the past two years has been tradable bank debt. Since the start of 2015, the three-month US dollar London Interbank Offered Rate (Libor) has risen from 35 basis points to 233.
Tradable bank loans have coupons set at a spread above Libor. So a loan fund ought to have been a buffer against rising interest rates, right?
Wrong. Performance has been surprisingly muted. And today, even as short rates are set to rise still further, there are additional reasons to think that the sweet spot in high yield might be found elsewhere.
Before the financial crisis, bank loan mutual funds were a niche. Since then, their popularity has grown spectacularly. The first wave of interest came from high-yield investors looking for a safety buffer: Loans are traditionally senior in a capital structure to bonds and secured against assets. The subsequent waves broke as interest rates lifted out of their post-crisis depths.
As Libor passed the 100-basis-point threshold at the beginning of 2017, flows really took off. It was an important moment because most loans only begin to reset their coupons once Libor is over this 1 per cent “floor”.
US loan funds have enjoyed substantial inflows in all but one month of 2017 and 2018.
High yield bond funds, by contrast, suffered substantial outflows during 2017 and in all but one month year-todate. That rotation is all about investors looking for a buffer against rising rates.
Rising libor
To be clear, loans have outperformed similarly rated bonds over the past 18 months.
The Libor-plus coupons have not been as generous as investors might have assumed, however, and we now believe that risks in the sector are building, too.
For the first nine months of 2017, three-month Libor climbed from 100 basis points to 130 but the weighted average loan coupon declined, from just under 500 basis points to 480.
That was because loan investors get very little “call protection”: Borrowers are free to call their loans early and refinance them, and they were doing so with lower coupons as demand exploded. Libor can rise by 30 basis points, but if the coupon spread over Libor declines by 40 basis points, investors end up getting less.
In short, loans have been defensive relative to high yield bonds, but were not necessarily a way to cash in on rising rates.
Today, we are concerned that they may not even be defensive.
Demand for loans has been so strong that high yield issuers have all but ceased using the bond market.
This year, the loan market has grown at a record-breaking rate. At $1 trillion (Dh3.67 trillion), it is now just $200 billion short of the bond market.
The effect of that has been to reduce or even eliminate bonds from capital structures. Loans are only senior if there are bonds junior to them.
Otherwise, the credit quality of loans begins to look very much like that of bonds. Add less restrictive loan covenants — the constraints on borrowers that protect investors — and the two sectors begin to look almost indistinguishable.
Back in 2010, the split between BB and B or CCC rated loans was around 50/50. Now, B and CCC rated credits make up almost 70 per cent of the market.
We do not anticipate an imminent train crash in loans. We do think it might be time to look elsewhere in high yield for the most attractive current opportunities, however.
Risk factor
High yield bonds carry some interest rate risk, but with the two-year US Treasury yield at 2.5 per cent and the five-year at 2.8 per cent, much of the coming cycle may be already priced in.
When we look at seasoned high yield bonds that were issued shortly after the financial crisis and now have one to three years until maturity, we find investors can build portfolios with a yield to worst of around 4.5 per cent to 5 per cent.
We believe that this short-dated high yield bond profile is attractive, especially relative to the perceived — but probably illusory — comforts of floating rates and higher credit quality in the highly popular loan market.