Leveraged loans are essentially the senior-secured version of high-yield bonds (due to their senior position in the capital structure, and collateral security), with the added feature of a floating coupon. Particularly relevant for the new oil paradigm is that loan indices and most loan funds have slightly less than 5% exposure to energy, as compared to 15-20% in high-yield (HY) bonds. Therefore, leveraged loans are a safer play if you are concerned with the impact of lower oil on the US shale oil producers. So if you do not have the stomach for market-timing long-short strategies, and particularly if you believe that the Fed will hike rates meaningfully due to an improving economy, loan mutual funds and ETFs, profiled herein, offer a compelling high-yield investing alternative.
The leveraged loan asset class benefits from several structural, fundamental and technical characteristics:
Structure is senior-secured with a floating coupon
Senior secured: From a structural standpoint, loans are senior in the capital structure, above bonds, and have a first-lien claim on the company's assets. As a consequence, loan recoveries have averaged 70-80%, vis-à-vis 30-40% in HY bonds. Loans also have contractual covenants, such as maintenance of financial ratios; however, these controls have fewer teeth with the resurgence in "covenant-lite" deals.
Floating rate: Leveraged loans have surged in popularity among retail, due to the floating-rate nature of loan coupons. The loan coupon typically resets higher with 3-month Libor, which is closely correlated to longer-term rates along the Treasury curve. However, for the coupon to reset, Libor must exceed the "Libor floor," which is, on average, 1% higher than current Libor. Thus, if the Fed only lifts rates by 1%, your return will not benefit from higher policy rates, but will be based almost entirely on credit spreads and liquidity. By contrast, if your view is that the Fed will raise rates by 2% or more, you have a nice hedge against higher rates, as long as credit remains benign.
In fact, leveraged loans have historically performed better than bonds and stocks in most rising rate environments. According to Merrill Lynch research, for instance, when the 5-year Treasury rate rose 121bp between April '99 and October '99, the total returns on loans were +2.6%, versus -2.3% for HY bonds and -4.9% for the S&P 500. Loan manager Sankaty quantifies that:
"Over the past 15 years, in periods where Treasury yields have been rising, annualized returns on leveraged loans have exceeded those of high yield bonds by approximately 70 basis points and those of investment grade bonds by over 600 basis points."
Fundamentals are supportive
Average debt/EBITDA ratios for loans have risen from the 4% area in 2009 to the 5% area today, which is similar to loan leverage in the 2004/05 period. The S&P LSTA loan default rate is at historic lows, reaching 3.33% (by amount) in November, and only 0.39% excluding the default of Energy Future Holdings (EFH), which most count as a casualty of the 2008 financial crisis. Loan managers polled by S&P predict that the loan default rate will finish 2015 at 1.64% and 2016 at 2.52%, versus a historical loan default rate average of 4.5%, which also happens to be the UBS credit strategy team's forecast for the HY bond default rate by mid-2016. The difference between the projected loan and HY bond default rates is primarily due to energy exposure being roughly 3x more prevalent in bonds.
Loan technicals include robust demand and lower supply
The technical are quite strong for leverage loans. Essentially, there is fixed, or growing, demand from primarily CLOs and retail that is meeting reduced supply, which should tighten spreads, all else equal. Whereas HY bond issuance is ahead of last year and on par with 2012 and 2013, loan issuance is the second lowest in five years. In an 18th February report, Merrill Lynch's high-yield strategy team, which prefers leveraged loans to HY bonds in the current market, wrote:
"One of the main reasons for our bullishness (on leveraged loans) stems from our belief that issuance will continue to be depressed this year as refinancings drop by 20% YoY, LBO/dividend recap financing falls 25% and M&A increases just 10%."
It is the demand from CLOs, the 60% buyer of the loan market, which provides the greatest confidence for loan spreads remaining tight. Wall Street is forecasting another bumper year for CLO issuance, in the $100bn area, and there is plenty of demand from institutional investors for AAA CLO paper at L+150. In the current tight spread environment, where investors are reaching for yield as non-US central banks continue to ratchet rates lower, there is probably room for outsized AAA CLO spreads - the plurality of the CLO capital structure - to tighten. Lower AAA CLO spreads boosts the arbitrage to the CLO equity buyer, which spurs more issuance, and thus, more demand for loans.
Loan return characteristics are favorable for retail
Loans have relatively low return volatility and low correlation to stocks. For instance, in 2014, when there was pressure across all credit, the S&P LSTA loan index returned 1.6%, versus 2.5% in HY bonds. However, loans' monthly return volatility was only 1.8%, versus 4.9% in HY bonds. Finally, loans' correlation with the stock market is close to zero and far lower than HY bonds', largely due to the favorable structure in the loan asset class.
The loan fund market and challenges for ETFs
The leverage loan fund market is roughly $140bn in size, with only $6.8bn of that represented by loan ETFs. Of course, $6.8bn in loan ETFs is only a fraction of the $270bn bond ETF market, despite roughly $770bn in outstanding loans. The reason for the underrepresentation by loan ETFs is the lower liquidity in loans vis-à-vis bonds. For instance, loan settlement is roughly 22 days, versus 3 days for bonds, and loans trade less frequently than bonds. However, there are liquidity-enhancing features in loan ETFs that mitigate liquidity issues, including small allocations to more liquid HY bonds, credit lines and cash allocations, all of which together can represent 50% of the fund.
The issue is that in volatile times, the loan ETF can trade at a lower price than the Net Asset Value of the constituent loans. Still, the risk is probably worth taking to get the efficiency of an ETF with its lower fees and ability to short. If you are uncomfortable with loan liquidity risk in the ETF, but want exposure to the asset class, a loan mutual fund is the alternative.
Mutual funds are the primary retail vehicle for loans
According to Morningstar, there are over 200 loan mutual funds and 24 closed-end funds. Many of the closed-end variety are leveraged 25% on average, however, making them more volatile. An evaluation of loan mutual funds on offer is beyond the scope of this report; however, Morningstar's loan fund database is a great place to start when selecting a suitable fund. I would also steer readers to US News' database for its top-ranked loan funds, which has a useful one-year return line graph next to each fund, on the front page.
Four ETFs track the loan market
The largest loan ETF, at $5.7bn in assets, is Invesco's PowerShares Senior Loan Portfolio ETF (NYSE:BKLN), which is mostly BB and B loans constituting the S&P/LSTA Leveraged Loan 100 index, which has 4.7% exposure to energy. BKLN has roughly 5% exposure to credits rated below B, a dividend yield of 4.01%, and a YTD return of 1.03%. See the LSTA website for extensive data and analysis on the performance of the bank loans in its index.
The remaining three loan ETFs each have assets under $1bn. The SPDR Blackstone/GSO Senior Loan ETF (NYSEARCA:SRLN) has a dividend yield of only 3.79%, but it has returned 1.96% YTD. Next is the Pyxis/iBoxx Senior Loan ETF (NASDAQ:SNLN), which has a loftier 4.22% dividend yield and a 1.90% YTD return. Last is the First Trust Senior Loan ETF (NASDAQ:FTSL), which has a relatively low dividend yield of 3.28%, but a very respectable YTD return of 2.29%.
The leveraged loan asset class has attracted a great deal of capital flows from retail, particularly over the last six years of the Fed's zero interest rate policy. The reason is simple: retail investors prefer floating-rate coupons over fixed-rate coupons in bonds. To the extent that the Fed lifts rates due to a buoyant economy, credit and liquidity risks should remain subdued for the foreseeable future. However, if oil does persist lower, it is comforting that loans have only roughly 5% exposure to energy, vis-à-vis 3-4x greater energy risk in HY bonds.
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