Bank Loans: December’s sell off and the potential impact on 2019 returns

The sell off was technically-driven and loans remain an attractive allocation.

Jan 18, 2019 | Invesco Fixed Income

Last year, the senior secured loan asset class outpaced traditional fixed income assets through the end of October. However, in November and December, bank loans experienced heightened volatility. Unlike prior bouts of volatility, higher quality “BB”-rated loans and the larger, more liquid loans significantly underperformed smaller loans and the “B”-rated segment of the market. This reflects that the selling was technically driven and motivated less by credit concerns than by sellers’ need to raise cash for redemptions. 

Retail investment vehicles and ETF products had significant outflows, mostly driven by an overall “risk off” market sentiment and a perception – mistaken in our view – that loans have become less attractive as expectations for further interest rate increases have diminished. Retail, or Prime funds saw nearly US$10 billion of outflows in December alone.1 Of note, today retail funds represent roughly US$177 billion—or 15% of the US$1.15 trillion US loan market. Compare this to five years ago when prime funds had much greater influence holding a similar dollar amount (US$165 billion) of a much smaller (US$680 billion) market—or roughly 24% of the total market.
 

  Dec-2018 4Q2018 2018

S&P/LSTA Index 

-2.54% -3.45% 0.44%

S&P/LSTA 100

-3.16% -4.41% -0.62%

BB Loans 

-2.56% -3.50% -0.42%

B Loans 

-2.52% -3.29% 0.86%

Source: S&P LCD as of December 31, 2018 returns represent total returns in USD.
 

Despite the year-end volatility, market fundamentals for senior secured loans have remained unchanged. Since the financial crisis, balance sheets in the corporate sector are in much better shape, allowing them to add leverage since 2011. Corporates have benefited by the Trump tax cuts, while the Conference Board’s index of consumer confidence is hitting its highest levels since 2000. Investment spending is up to 17.6% of GDP (from 13.9% in 2010) and consumers are seeing improved job and wage growth. With consensus GDP growth estimates in the 2.6% range and CPI growth estimates of 2.1% for 2019, corporates are in a healthy position to absorb the effect of higher interest rates. 


Senior secured loan default rates remained low at 1.63% at year end—roughly half the historical average default rate for the asset class.1 Fundamentally, loan issuers continued to post strong year-over-year EBITDA growth—indicating companies’ debt service burdens should remain manageable and improving the prospects for a prolonged low default rate. At the end of 2018, loans risk premium of L+5.06% was 122 bps above the historical average and would imply an expected default rate of 6.64%-- four times higher than the current default rate.

During the first few trading days of 2019, we have seen a reversal in the senior secured loan market, demonstrated by a rebound in market prices and the stabilization of retail flows. Note the higher performance of the S&P/LSTA 100 loans and BB-rated loans that experienced the greatest volatility in December. 
 

 

YTD through 1/11/2019 

S&P/LSTA Index 

2.43% 

S&P/LSTA 100 

3.47% 

BB Loans 

2.79% 

B Loans 

2.35% 

Source: S&P LCD as of January 11, 2018. 

 

Invesco’s view, given the year-end weakness was largely technically driven, is that loans continued to represent an attractive allocation due to the following factors: 

 

  1. Loans have provided attractive current income through all market cycles—even stressed and defaulted loans typically pay current interest
  2. Loans have had less volatility than traditional assets—including fixed income
  3. Loans have typically exhibited a high risk adjusted return
  4. Loans are senior and secured and the first to get paid back—a comprehensive credit risk mitigation mechanism
  5. Loans have had low correlation to traditional assets—providing potential benefits with portfolio diversification
  6. Loans have minimal duration risk—providing a hedge against rising interest rates.

JPM Leveraged Loan Index, JPM US HY Bond Index and JPM US Aggregate Bond Index as of Dec. 31, 2018. An investment cannot be made in an index. Returns represent total returns in USD. Past performance is not a guide to future returns. 
 

While expectations for further interest rate hikes in the US have been tempered, it is important to recognize senior secured loans’ historical return profile and note that the overall coupon—not net increases in interest rates—have been the primary driver of returns historically, while also contributing to the overall stability of the asset class. In fact, senior secured loans have only experienced two negative years over the past 26 years. They include the Global financial crisis in 2008 and in 2015 following the fourth quarter concerns over a collapse in oil prices and economic weakness in China.1 In both instances, the asset class produced a strong recovery rally the following year, like what we have seen in the first few trading days of 2019. 

The following chart compares the “excess return” over the past 20 years for senior secured loans to its traditional corporate credit counterparts—investment grade and high yield. Once you factor out the interest rate and duration component of returns within each asset class, bank loans (both market and BB index) outperform investment grade and high yield on a cumulative basis.  As expected, in only two of the last 20 years—2001 and 2008—did investment grade outperform loans and high yield on an excess return basis. Also meaningful, excess returns for loans outperformed investment grade in 16 of the past 20 years.    
 


Source: IG Corporates represented by the Bloomberg Barclays Corporate Index; Loans and BB loans represented by the Credit Suisse Leveraged Loan Index; high yield bonds represented by the Bloomberg Barclays US high yield index. Excess return refers to return over the risk free rate of a similar duration as the respective indices. From Dec 1999- Dec 2018. Past performance is not indicative of future results.  

 

Looking forward to the rest of 2019, we reiterate our 2019 outlook piece where we expect loans to generate approximately 5.25-5.75% total returns. Central to this forecast is the supportive fundamental credit environment which we believe will persist throughout the year. While idiosyncratic challenges could pressure returns for lower quality issuers, we believe that the higher quality part of the market has the potential to exceed our total return forecast.  We believe that market pullback at the end of last year should result in new issue activity with higher spreads and better structure—supporting the senior secured lenders. We anticipate that the higher quality issuers balance sheets are well positioned to weather a simultaneous rise in short term rates and a multi-year earnings recession resulting in a potentially favorable low default environment of 1.5-2.0% in 2019.3
 

From a demand perspective, we expect the market to remain reasonably well bid due to continued CLO issuance and further allocations from large institutional investors. Retail flows, a far less consequential contributor to overall loan demand, will likely correlate to interest rate expectations as is typical. On the supply side, we expect new issuance volumes to be approximately in line with 2018 levels. M&A and LBO financing, the primary drivers of new issuance, should be supported by the recent pullback in equity valuations. Private equity sponsors have raised significant capital that has yet to be deployed into new investments, and loans have increasingly become the financing vehicle of choice for LBO transactions. Overall, we foresee balanced supply and demand in 2019, a relatively stable trading environment, and thus no sustained pressure for new issue spreads to go substantially wider or tighter.

Notwithstanding uncertainties, we expect 2019 to be another solid year for senior secured loan due to supportive fundamental credit conditions, strong current income, and limited near term default risk. As we progress towards a potential end to both the Federal Reserve’s rate tightening cycle and the current economic cycle in the coming years, we believe loans could continue to produce attractive risk adjusted returns, and given their defensive positioning in issuers’ capital structures, their high level of income and relatively low historical volatility in weak environments, warrant consideration as an allocation in investors’ portfolios.  
 


Sources
1. S&P/LCD as of December 31, 2018
2. Risk premium is 3-year discount margin of CS LLI. Historical risk premium spans from Jan 2000-Dec 2018, excluding 2008 and 2009 as outliers. Implied default rate calculated by ISSM utilizing CS LLI as of December 31, 2018.
3. Estimated by Invesco Senior Secured Management, Inc.


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