Floating-Rate Loan Investors: Clairvoyant or Missing Out?
Summary
- In a rising rate environment, we put floating-rate loans high on the list of fixed-income investment classes likely to perform well in 2015.
- In a stark disconnect from the current reality, retail investor demand remains decidedly absent.
- With demand for loans increasing from pension systems, endowments and foundations, are investors losing out?
Even though we’ve managed loan strategies for more than 25 years, we still approach the market each day with humility. Questions like “What can go wrong?” and “What are we missing?” are perpetually swirling inside our craniums. After all, they call them blind spots for a reason. Not to mention that as fixed-income people we’re somewhat pre-programmed with a heavy dose of pessimism in the first place. In the end, however, our analysis always comes down to the facts. Things that can be quantified and measured. And in the sub-investment grade debt arena, that mostly means cold, hard corporate credit statistics and a fact-based assessment of the broader economic context. Over time (emphasis), these are the factors that ultimately drive one’s return experience in our asset class. That is, you begin by clipping the coupon (i.e., your income return), then avoid or don’t avoid default scenarios (i.e., your price return), the sum of which equals your total return. Of course, the technical factors of supply and demand matter most in the very short run – we’ll get to these – but over time it’s really about the fundamentals. This is fairly straight forward.
What’s less easy to understand, for us, is the continued behavior of retail fund flows. In short, we see a stark disconnect: The underlying investment prospects are bright, in our view, yet retail demand remains decidedly absent. As we study the facts, we put loans high on the list of fixedincome investment classes likely to perform well looking ahead, what with the solid fundamental backdrop in the U.S., credit-risk-taking broadly in check and market technicals positioned for strengthening. Overall corporate indebtedness in the space has been easing, not climbing, thanks in no small part to increasing regulatory focus on limiting credit risk. As a result, debt-to-EBITDA ratios are now lower than last year and remain well within the asset class’ long-term historical fairway. On debt serviceability, interest coverage remains near all-time highs. And on maturities, only 2% of the market outstanding is coming due this year or next, with maturities for the rest of the market nicely feathered out from 2017 to 2021. While there are sure to be individual trouble spots – there always are – taken at large we see a healthy, thriving corporate loan market. To be sure, today’s default rate, by definition a trailing indicator, affirms this view: the rate sits at just 1% of issuers.
Despite this relatively rosy fundamental picture, supply/ demand technicals over the past year have been weak – thanks by-and-large to the aforementioned weakness in the retail segment. Good reasons why retail folks have exited escape us, though we’ve heard a number of popular explanations advanced: a sub-coupon return last year, negative headlines on credit risk and our favorite – “I don’t think interest rates are going to rise”. As we look at the facts, we see last year’s dip as decidedly non-permanent, meaning last year’s coupon-minus experience had little to do with defaults and mostly to do with flows – thus having a good chance, if history is any guide, of driving a couponplus experience this year. All you have to do is look back to 2011 and 2012 – a case in point. On rates, whether they rise or not seems mostly irrelevant. If nothing happens, loans offer a chance to earn 4-5% coupon income, take on close to zero interest-rate duration (just in case), and possibly achieve several points of upside as market technicals revert and/or loans naturally accrete to par.
From what we hear from advisors, the list of asset classes in which they expect forward returns north of 5-6% is pretty short – so why snub loans? The Fed appears prepared to raise policy rates later this year, which means several potential positives for the loan investor: higher income (albeit following a roughly 0.75% LIBOR floor delay), a favorable economic picture (the Fed is signaling they view the economy well on track) and an opportunity to get in front of a reversal of technical conditions (retail demand, the one main soft spot of late, has tended to correlate with higher short-term rates).
Does retail see something that all the institutions are missing? While it’s possible, our review of the facts leads us to think probably not. In the end, it’s a zero-sum game: the guaranteed loss locked in by exiting retail investors is being picked up by pension systems, endowments and foundations, structured products and corporate cash accounts. They see good value in loans, and so do we.
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