Boston - Just seven short weeks ago, the floating-rate loan market was standing tall with a 4.0% year-to-date return through October. Not only were loans on pace for the 5%+ calendar year mark that many anticipated, they had performed with remarkably low volatility and a performance profile that trumped all major asset classes.
Loans had outpaced U.S. stocks, investment-grade corporates, high-yield bonds, government bonds, emerging market debt and many other segments across the capital markets. All of these areas had suffered from a broad repricing of risk, coincident with a Federal Reserve on the move. Yet loans, thanks to their anti-bond character and near-zero duration, proved yet again to be broadly immune to rates.
Enter the Grinch.
Alas, loans' healthy year-to-date return has quickly been reduced to less than 1%. As of Dec. 20, the S&P/LSTA Leveraged Loan Index now reports a year-to-date return of just 0.97%. To be sure, if the year ended today, loans would still be one of the best-performing asset classes of the year. Yet we expect this is cold comfort for loan investors who have watched the average price of loans dwindle from 98.6 in early October to 94.5 today. Where did those four percentage points go, and why?
Here's some (comfort) food for thought ahead of the holiday week:
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Today's average dollar price of 94.5 implies a 27% default rate, if one assumes loans' historical 80% recovery, according to Moody's. In other words, if future recoveries on defaulted loans are similar to those of the past, what default rate would be needed in order to make 94.5 "the right number?" The answer is 27.5%. If 27.5% of loans default, credit losses would be 5.5%, assuming the 80% recovery level referenced. If one assumes a 70% recovery, the implied default rate is 18.3%. And for a real pessimist who assumes a 60% recovery, the implied default rate is 13.75%. For reference, the cumulative default rate in the great financial crisis was 15%.
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Yet the actual real-world default rate is just 1.6%. Not 27% or 18%. Talk about a disconnect. Granted, default rates are backward-looking measures of what's already experienced trouble. So perhaps consider the market's distress ratio, which tracks loans trading below 80. Many look to this figure as a forward indicator of credit stress. Today the distress ratio is just 2%. And further, the percentage of loans trading below 70 -- generally considered to be a level of deep distress -- is just 0.4%. Despite recent volatility, these numbers suggest the market is not anticipating credit troubles. What's more, third-party surveys of loan portfolio managers paint a similar picture. According to S&P's latest survey, consensus expectations are for a default rate of just 2.2% by year-end 2019, less than one percentage point higher than today's level, and well below the market's 3.1% long-term average.
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Volatility has been technically driven by flows. After steady inflows into the category in 2017 and the first ten months of 2018, retail loan fund flows turned negative the week prior to Halloween. Category flows have been negative for six of the last eight weeks, with the pace of outflows having picked up in December. Reading the tea leaves (and speaking with clients), the reasons for the departures appear to be a combination of the Fed's recent change in tone regarding the pace of future hikes, the barrage of negative headlines that have consistently dogged this asset class and a general "snowball effect" that we periodically see in the retail segment. Lower prices beget redemptions, which beget lower prices, and so on.
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"Re-tail" can wag the dog in loans -- but not for long. We say this from experience, and the performance data prove it out. Many don't realize that retail loan funds represent a small market segment in this asset class. Funds represent about 12% of outstandings, down from 13% at the start of the year. So the small fish of retail is now a little smaller in loanland. Yet retail can tilt the supply/demand balance in short spurts of time (like what the market is experiencing now) as institutional investors represent almost 90% and are generally buy-and-hold, strategic investors. Despite its small size, the retail retreat has driven the soft market of late.
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Rebounds tend to be quick and relatively V-shaped. Loans are a unique asset class that historically do well to diversify portfolios. They are the zig for the common zags prevalent elsewhere in client portfolios. Loans can periodically prove frustrating at times like now, but the rebounds tend to be quick and relatively V-shaped. Loans' short average life and senior/secured profile are among the reasons. Historically, forward returns from these kind of levels have been some of the asset class' best. If this sounds like opportunity knocking, open the door. Look at 2011. Loan returns were just 1.5% that year when Ben Bernanke introduced his zero interest rate policy. This was followed by the 9.7% rebound in 2012. Look at 2015. Loans were down 0.7% amid worries surrounding commodities. This was followed by the 10% rebound in 2016. Past performance guarantees nothing, but the pull-to-par nature of this market hasn't failed yet.
Bottom line: Loans may once again be a "coupon-plus" investment proposition. Additional Fed hikes are gravy if they materialize, but the main attraction of loans now is high income and the reversion to the mean on the price. We truly suspect the Grinch will not stay long. Capital tends to flow toward value (eventually), and the newly created value in loanland has just delivered a holiday gift for those looking for attractive return sources for 2019.
The value of loan investments may increase or decrease in response to economic, and financial events (whether real, expected or perceived) in the U.S. and global markets. Loans are traded in a private, unregulated inter-dealer or inter-bank resale market and are generally subject to contractual restrictions that must be satisfied before a loan can be bought or sold. Loans may be structured such that they are not securities under securities law, and in the event of fraud or misrepresentation by a borrower, lenders may not have the protection of the anti-fraud provisions of the federal securities laws. Loans are also subject to risks associated with other types of income investments. Investments in debt instruments may be affected by changes in the creditworthiness of the issuer and are subject to the risk of non-payment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer's ability to make principal and interest payments.
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