After Proving Themselves in the Crash, Loans Now Seen as 'Third Asset Class'

by: Steven Bavaria

Bankers and loan investors have been promoting floating-rate corporate loans as a “third asset class” – besides stocks and bonds – for many years, but lately the investment world has really begun paying attention. It seems like the stars are finally aligned for an investment that has been characterized as dull and boring, even by its greatest admirers, but whose steady cash flows, solid collateral security, and natural hedge against rising interest rates and inflation seem perfect for these “new normal,” uncertain times.

Proving themselves through the recent financial crash – which loan market types sometimes call the “great de-leveraging” – didn’t hurt loans’ reputation either. Although floating-rate loans took a 29% hit in 2008 (as other major investments got socked as well), they came roaring back with a 52% increase in 2009, gained another 10% in 2010, and are up 2.3% for this year through March 8. (Returns are for the S&P/LSTA Leveraged Loan Index, the industry standard.)

As retail investors have come to appreciate the advantages of floating rate loans (which will increase in value as interest rates rise) over high yield bonds (whose value will drop as rates go up), they have been pouring money into loan mutual funds; over $7 billion of new funding in 2011 alone, according to Standard & Poor’s.

Investors now have more vehicles available than ever for getting into the senior loan asset class. Just last week, Invesco PowerShares launched the first loan market ETF, the Senior Loan Portfolio (NYSEARCA:BKLN). The number of traditional open-end loan mutual funds has grown to 61, although only one of them (Fidelity Floating Rate High Income Fund – FFRHX) is no-load. Closed-end funds also continue to be a popular vehicle for investing in loans, with 21 currently listed by closed-end site CEF Connect (see link below).

The floating-rate loan industry, knowing that its asset class is a natural for uncertain economic times where the clear bias is toward rising inflation and higher interest rates, has been out marketing itself to the broader investment community. Just last month the industry trade group, the Loan Syndications and Trading Association (LSTA), with several of its members, sponsored a special supplement in Pension & Investment magazine, in order to reach the institutional investment industry that has traditionally focused its investing attention primarily on stocks and bonds.

Still not too late for retail investors

Although investors who got into loans last year or earlier have done very well (just as equity and high-yield bond investors have done), floating rate loans still look attractive, especially in relation to other choices like equity and – especially – fixed-rate bonds. Even if, from this point forward, we just make the coupon – about 4% – that’s a pretty good return when you consider that it also comes with a built-in inflation hedge (if you assume, as I do, that inflation will bring higher interest rates along with it.) Many people, in this “new normal” investing environment, might regard an assured 4% plus an inflation/interest rate hedge to be somewhat “equity-like.” With loans, you sacrifice the bigger upside that equity offers, but also remove much of the potential downside.

Investors who just want to make the S&P/LSTA Leveraged Loan Index return, can buy BKLN, as mentioned above. Investors who want to make a bit more can buy a closed-end fund, most of which are slightly leveraged (limited to 33% leverage) which – as long as borrowing rates stay below what they’re earning – can add another 1-2% to their yield (plus whatever “Alpha” the individual portfolio manager adds through smart loan picking).

Investors may wish to limit their choice to closed-end funds that are still selling close to or below their net asset value (several have risen to premiums in recent months as the loan asset class has gotten more popular), like:

  • Invesco’s Dynamic Credit Opportunities (NYSE:VTA)
  • ING Prime Rate (NYSE:PPR)
  • Black Rock Floating Rate (NYSE:FRA)
  • Invesco Senior Income (NYSE:VVR)
  • Nuveen Floating Rate (NYSE:JFR)

There are several other loan funds that are fine portfolio candidates (several Eaton Vance funds, for example, which I own) but their premium prices currently make them relatively less attractive. Check out these and other closed-end loan funds, as well as other closed-end funds on CEF Connect (Just screen for “Taxable Income/Loan funds”) here.

The open-end funds, especially Fidelity’s FFRHX, represent another attractive way to invest in the loan market, but you pay a price in the form of a reduced yield for the overnight liquidity that traditional mutual funds offer, in that the fund manager has to maintain a substantial portion of the fund in cash – about 13% of the Fidelity fund, for example – to meet daily fund liquidation requests. (See below for more information about the loan asset class.)

Floating-rate loans: A “primer”

Senior, secured corporate loans are debt, generally issued by the same cohort of companies that issue high yield bonds. But they have two very important differences:

  • Unlike fixed-rate bonds, whose value drops as interest rates increase, floating-rate loans have coupons that are re-adjusted periodically, usually every three months, so your income stream increases as interest rates rise.
  • Loans are senior obligations, secured by collateral, whereas bonds are typically unsecured or even subordinated, so the borrowers’ assets are used first to pay off loans in the event of default or bankruptcy, before bondholders receive anything; as a result, credit losses on loans average less than half the losses on high yield bonds.

What many investors like about floating-rate corporate loans is that you can invest in a “pure” credit instrument, without also having to buy an embedded “interest rate bet” along with it. The interest rate bet was a nice additional feature for the 30 years from 1980 to 2010, because interest rates trended down – ultimately way down – during that period, providing a big extra boost to returns on top of just the coupon. But with rates at record lows as they are now, it seems like the interest rate bet embedded in bonds is more likely to be a headwind and a drag on earnings than a headwind going forward.

Buying loans, where 100% of the coupon is a return on taking credit risk, seems like a much better bet at this time in the cycle. In addition, loans pay investors more for taking the credit risk. According to Standard & Poor’s and Dow Jones, the average current yields on loans and high yield bonds are 4.5% and 6.8%, respectively. But 2.76% of that high-yield bond yield is actually a premium for taking the fixed rate interest rate bet. We’re using the 7-year treasury bond yield (2.88%) minus the yield on the 3-month treasury bill (12 basis points) to determine what the market pays you for taking pure interest rate risk for the 6 ¾ year difference in duration between floating rate loans and fixed rate high yield bonds.

What this analysis shows is that when you remove the portion of the high yield bond coupon that actually pays the investor for interest rate risk, what’s left – 4% – is less than what loan investors get paid for lending to the same cohort of borrowers. And the loan investors are lending higher up the balance sheet, so they are actually getting paid more to take less risk. When the higher recoveries (and therefore lower credit costs for loan investors) are factored in, the gap between loan and high-yield bond returns becomes even greater: 3.9% for loans vs. 2.8% for bonds, assuming a fairly typical annual default rate of 2%. (If you are more pessimistic about the future credit environment and assume a higher default rate, the relative advantage of loans over bonds becomes even greater.)

Disclosure: I am long VTA, PPR, FRA, EFT.