Since writing two articles on leveraged loans (Part 1 and Part 2), these closed end funds and ETFs have performed nicely. The speculative grade market emerged from the financial crises as a strong asset class. Irrelevant of the choice of fund, most of loan funds performed well. Even a laggard, PHD, returned over 13% this year and additionally paid a dividend of 6.4%. Yet the economy is cyclical. It is prudent to re-evaluate these investments.
Predictions for the year ahead by the rating agencies are still good. These predictions are usually accurate in forecasting the performance of these assets. The rating agencies also indicate that some warning signs are emerging. Despite these early warning signs, in the near term these funds could continue to produce solid dividends and returns for investors.
Pioneer Floating Rate Trust
Nuveen Floating Rate Income Fund
Eaton Vance Senior Floating-Rate Trust
Nuveen Floating Rate Income Opportunity Fund
Similar to the economy, the leveraged loan market is also cyclical. After the financial crises, leveraged loans performed extraordinarily well. During most expansionary times, these assets tend to have good returns. Losses due to bankruptcy are low allowing investors to collect abnormally high coupons. When the business cycle starts to decelerate, investors should take precautions. In the financial crises, this asset class' value was cut in half. It did bounce back nicely, but the volatility was high.
In order to further analyze these investments, three areas are important. Credit spreads and default rates are two simple ways to characterize expected returns. Downgrades are an important metric in predicting more future problems.
Coupon / Credit Spreads
Investors in leveraged loan ETFs and closed end funds are usually income-oriented investors. The ability of these vehicles to pay dividends is based on the credit spreads of loans. During the credit crises, the market was reluctant to lend money. The yields on loans were very attractive. Liquidity has returned to the market. From a low prices of almost 50% of par, loan prices have significantly appreciated. Prices have almost completely recovered. Most of investor returns will come from loan coupons. Credit spreads have also contracted from crisis wides. Leveraged loans yields will continue to compress as defaults are low and liquidity is abundant.
Spreads have declined over 1% in the past year. Yields are currently below their one-year and five-year moving average. Therefore, investors should not expect yields to increase. Unless credit conditions worsen or liquidity starts to erode, yields will not rise. If this happens, investors should be wary of higher dividends and should probably consider selling.
Default rates also follow the business cyclical. Defaults are high during recessions and low when the economy is expanding. In this cycle, the default rate was at is lowest in the middle of last year. It stood at 1.9%. Defaults have increased since last summer. The risk is now to the upside. Currently, the default rate is a little less than 3%. This is still below its historical average of 4.5%. The rating agencies vary on their outlook for defaults next year. However even in the most pessimistic prediction, defaults are projected to be below the historical average.
Upgrades to Downgrade Ratio
Ratings are generally forward looking. Rating agencies start downgrading more when company fundamentals deteriorate. Therefore downgrades lead default rates. Year-to-date, Standard and Poor's has downgraded 195 credits while upgrading only 134 companies. By year-end the number of downgrades will most likely exceed 2011's total of 209.
This implies that defaults rates will continue to rise for the foreseeable future. Yields will also continue to decline. Yet, these leveraged loans still appear to be good investments for the next year or two. It is important to continue to monitor signs of trouble. However, these investments will continue to pay good dividends and could still appreciate modestly.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.