By Heather Rupp, Peritus Asset Management
Investing in floating rate bank loans has been a popular strategy this year given investor concern about higher rates. We have seen positive fund flows into floating rate loan mutual and exchange traded funds (ETFs) in 15 of the last 16 weeks, and so far this year $8.1 billion of inflows to loan mutual and exchange traded funds.(1)
At face value this seems like a “no brainer” trade, and many have embraced it as such, but the actual numbers tell a bit of a different story. For instance, 2013 was the last annual period in which we saw a meaningful increase in US Treasury rates, and during this period a whopping $63bn flowed into floating rate loan mutual and exchange traded funds.(2) However, in 2013 floating rate loans returned 5.3% versus 8.2% for high yield bonds.(3)
So even with the 10-year Treasury yield increasing by over 1.2% and the 5- year Treasury increasing over 1.0% (both over 50% from their respective yields at the beginning of year) (4) and a massive amount of inflows into the loan space in 2013, the high yield bond market, helped by higher initial starting yields, still outperformed the loan market, despite the fact that the high yield bond market saw slightly negative net outflows for the year.(5)
Another consideration when investing in the loan market must be an understanding of what the “floating” rate is tied to. Bank loans are generally based on short-term LIBOR rates, which doesn’t necessarily tie closely to longer term 5- and 10-year Treasury rates, which are the more relevant rates for high yield bond investors.
Related: The LIBOR Spike and Why It Matters
For instance all through 2013-2015 LIBOR was virtually flat, while Treasury rates surged. Then in 2016, we saw LIBOR increasing while Treasuries fell. It has only been over the last year and a half that LIBOR and the 5-year have been both moving upward.(6)
The relevant interest rate is important but so is understanding how the actual spread over that base rate works. Loans differ from bonds in that bonds are generally issued with a non-call period covering the first several years after issuance, and then have a set call schedule indicating premium prices at which the company can redeem the bonds over subsequent years.
Depending on the term of the bond, this often provides the investor call protection for much of the term of the security. However, with floating rate loans, that call protection period is generally a much shorter period of time. With a newly issued loan, you may have a non-call period for the first six months to a year or two, but many loans are issued with no call protection. Given the supply and demand imbalance in favor of issuers of late, there is often no call protection for loan investors at all.
Related: ETF Trends Fixed Income Channel
Why does this matter? Because the very minimal call protections can lead to constant “re-pricing” activity. This means that the issuer approaches the investor to lower the interest rate on the loan. The loan remains outstanding but now the investor is faced with a lower rate. So while investors have to approve the repricing, in times of high demand, it isn’t hard for issuers to get the repricing activity through (as the alternative is that they call the loan altogether and the investor loses the holding).
Over the past couple years we have seen a huge wave of repricings. In 2017, 45% of the $974bn in gross new issuance volume was related to repricings and so far in 2018, 48% of the $304bn in gross new issuance is related to repricings.(7) Index-based/passive bank loan funds track a specified index and thus largely hold the securities in that index. When a security is repriced and remains outstanding and part of the index, then these funds would be subject to a lower total coupon rate on that security.
In a period such as we are seeing now, interest rates can be rising via the LIBOR increase, so the base rate on the loan is increasing, but with the repricings that spread over the base rate can be falling, meaning the actual total coupon rate the investor receives may be actually falling, or at least going up much less than the LIBOR move would indicate.
An additional note, the general perception seems to be that loans are always less risky than bonds. In many cases we do see a bifurcated capital structure, whereby the company has a portion of their capital structure in a floating rate loan and revolver, which is senior in the capital structure and secured, and then the remaining portion of the debt issued is in subordinated bonds.
In instances such as this, we do see much less leverage in the loan portion of the debt, and thus less risk associated with it. However the reality is that many companies have debt financing that consists entirely of loans and some of those loans are still part of capital structures that are very highly levered. We continue to see the envelope being pushed by loan issuers with many so-called “1st liens” being levered north of 5x EBITDA (leverage multiple of debt to EBITDA). Debt levels over 5x EBITDA are not always a problem per se, but can be if the cash flow generation is not there to give the issuer some margin of safety.
In assessing the cash flow situation, investors need to look at the cash needs of the company (capital expenditures, debt service/interest costs, taxes, and other needs) relative to the EBITDA generation, and with a floating rate loan in a rising rate environment, the interest cost to the company can be increasing (versus the bond market where the coupons are fixed). EBITDA multiples are also important to consider as investors put a valuation on the company.
Finally, loans often carry a lower interest rate given they are considered less risky and are “secured” by the “assets” of the company, but when leverage multiples become elevated the value of that “secured” feature can be illusory. We believe that investors need to make sure they understand what they are purchasing in this space on both the credit and the coupon side. While we do currently see an opportunity in the floating rate bank loan market as a supplement to an existing high yield bond allocation, we believe this opportunity is for active investors who are able to decide what credits they want to own.
Active investors in the loan market are able to consider and invest according at the credit fundamentals and the security metrics. That flexibility can also allow the active investor to take advantage of the higher rates by investing in loans where they are not seeing repricing activity eat away the benefit of the LIBOR move. So for investors concerned about rising rates, we continue to see the high yield bond market as an attractive place to be positioned but do see the opportunity to supplement that bond allocation with an active allocation to the floating rate loan market, whereby investors can expand their opportunity set, take advantage of where in the capital structure they want to be positioned, and potentially benefit from the rising floating rates.
For more on investing in high yield debt in a rising rate environment, see our recent piece, “Strategies for Investing in a Rising Rate Environment.”
1. Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/11/18, https://markets.jpmorgan.com.
2. Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/11/18, https://markets.jpmorgan.com.
3. Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Leverage Loan Market Monitor,” J.P. Morgan North American High Yield and Leveraged Loan Research, January 2, 2014, p. 1.
4. Data sourced from the U.S. Department of Treasury website, Daily Treasury Yield Curve Rates, comparing 12/31/12 to 12/31/13.
5. Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/11/18, https://markets.jpmorgan.com.
6. Data for the period 5/15/13-5/14/18, LIBOR and Treasury data sourced from Bloomberg.
7. Jantzen, Nelson, CFA and Peter Acciavatti, “JPM High-Yield and Leverage Loan Morning Intelligence,” J.P. Morgan North American Credit Research, 5/2/18, https://markets.jpmorgan.com.
Although information and analysis contained herein has been obtained from sources Peritus I Asset Management, LLC believes to be reliable, its accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made in this report may not be suitable for all investors. As with all investments, investing in high yield corporate bonds and loans and other fixed income, equity, and fund securities involves various risks and uncertainties, as well as the potential for loss. High yield bonds are lower rated bonds and involve a greater degree of risk versus investment grade bonds in return for the higher yield potential. As such, securities rated below investment grade generally entail greater credit, market, issuer, and liquidity risk than investment grade securities. Interest rate risk may also occur when interest rates rise. Past performance is not an indication or guarantee of future results. The index returns and other statistics are provided for purposes of comparison and information, however an investment cannot be made in an index.
This article was written by Heather Rupp, CFA, Director of Communication and Research Analyst for Peritus I Asset Management, the sub-advisor to the AdvisorShares Peritus High Yield ETF (HYLD), www.advisorshares.com/fund/hyld, fund distributed by Foreside Fund Services, LLC. For questions, please contact Ron Heller, CEO of Peritus I Asset Management, LLC at rheller@peritusasset.com, 805- 879-5620.