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Why floating-rate loans are coming into their own
(pictured: Craig Russ)
In uncertain times, such as these, investors have traditionally turned to the fixed interest market for their downside protection. But this time it really might be different.
In the ‘new normal’ of low-to-zero-to-negative interest rates, investors may well be better off in the floating-rate debt market than taking on increasing duration – interest rate – risk from the traditional bond market. Bonds are not what they used to be.
One of the world’s leading exponents of floating-rate loans as an asset class, Eaton Vance, has produced a white paper, ‘The Timeless Case for Floating-Rate Loans as a Strategic Allocation’, which details the performance history of loans coupled with their increasingly important part in the portfolios of large and small institutional investors around the world. It is a compelling story, especially given the heightened uncertainty following Brexit.
Craig Russ, co-director of floating-rate loans at Eaton Vance, who has been portfolio manager there for nearly 20 years, describes floating-rate loans as an “addressable market”.
The loans are typically large and liquid, held by upwards of a hundred lenders and supported by a robust secondary market. Secondary trading represents about 70 per cent turnover of the market each year. In the US, the total market is worth about US$880 billion. When you add in Europe, it tips just above US$1 trillion.
At Eaton Vance, which manages about US$35 billion in the strategy, portfolios are diversified typically housing about 400borrowers at any point in time. Last year the firm researched over 150 transactions of which over 100 were “new issuers” to the market (meaning they are not a re-financing deal) and participated in about one third of them.
From the perspective of the entire fixed interest market, loan mandates have delivered the third-best returns, with a much better risk profile, of all debt asset sub classes over a long period. As the Eaton Vance paper points out, loans have come in at number three for returns after the higher-risk US high yield bonds and emerging market bonds, with a yield of 6.1 per cent for the 12 months to April. The global aggregate index, by comparison, produced a return of just 0.8 per cent.
Russ says the loan asset class is fundamentally very stable. “the senior loans typically represent less than 40 per cent of the value of the company, so there is a big cushion there. A lot has to go wrong for us to lose money.”
The stats are interesting. Loans are paid back in full and on time 97-98 per cent of the time, according to the averages. In the 2-3 per cent of problem cases the average return is 7080 cents on the dollar. The average cost to the investor of all this is about 40-60bps a year but the return, on average over a long time, is 400bps above LIBOR.
“We take less credit risk than the high-yield managers and we have no duration risk,” Russ says. “And we have no political or currency risk compared with emerging market debt.”
One of the basic features of loans is that their coupons reset every 40 to 60 days, on average, with adjustments that are calculated as fixed spread over a variable benchmark, typically LIBOR.
When you combine the facts that loans have had higher historical yields and lower duration than traditional bonds the net result is loans have the highest ratio of yield per unit of duration versus other major fixed-income sectors. It’s also worth noting loans have had low correlation with other sectors, thanks to their low interest rate sensitivity.
Looking back at previous periods of rising interest rates, when the US federal funds rate increased by 175 basis points for the 12 months ended May 2000, loans returned 3.9 per cent compared with minus 4.8 per cent for bonds. Most recently, when the US Federal Reserve raised rates from 1.0 per cent to 5.25 per cent over the two years ended June 2006, loans returned 12.7 per cent versus. 10.6 per cent for bonds.
Loans have a layer of credit protection that is unique in the corporate fixed-income market, thanks to their senior secured positioning in the issuer’s capital structure. In the event of default, the claims of loan investors are ahead of those for high-yield bonds and equity.
Because loans comprise 30-40 per cent of the capital structure, the junior layers of high-yield and equity amount to a “capital cushion” equivalent to about two-thirds of the enterprise value. In addition, loans are typically secured by specific corporate assets. This conservative “belts and suspenders” approach to lending has been very effective.
The history of loan performance over the past 20 years – part of the greatest bond bull market in modern history – provides important clues as to why loans may be key in forward- looking portfolio positioning as we begin the next 20 years.
“To us, the analysis underscores the importance of fixed- income diversification based on expected performance characteristics,” Russ says. “Generally, loans are at a relative disadvantage to traditional fixed income as rates decline and yields are reduced, but have a relative advantage as rates rise.”
Both interest rates and credit risk are cyclical. The insight that has made loans useful and enduring is that these cyclical risks can be managed through a prudent lending structure – one that benefits both investors seeking higher rates and below-investment-grade issuers seeking market access.
“In our opinion, the risks can further be mitigated with the due diligence and expertise of professional management – we do not believe it is a market that lends itself to the “commoditisation” of passive strategies” the Eaton Vance paper says.
“Because it’s impossible to pinpoint when the next rising rate scenario will occur, the track record of loans makes a good case for a strategic allocation – one that benefits from strong current yields, combined with ‘insurance’ for the day when rates tack back upward. Whether we are on the cusp of a new cycle of rising rates, or some ways away from it loans still offer an immediate benefit: the luxury of not having to make that call.”
