With the tightening monetary policy hurting stock (SPY, DIA, QQQ, IWM) and bond (LQD, AGG, BND, HYG, JNK, AWF) prices, there's one segment (among corporate loans) which is outperforming almost every asset class during this historically-turbulent month - leveraged loans (BKLN, SRLN, FTSL, SNLN).
First of all, what is a leveraged loan? This is a loan that is extended to (mostly) companies (but also individuals) that already have considerable amounts of debt and/or a poor credit history. As such, a leveraged loan is considered to carry a higher risk compared to a "regular" loan simply because the default rates are (expected to be) higher on leveraged loans. Due to their high/er risk profile, leveraged loans are given at much higher rates than those lenders agree to give "regular" loans at.
The Allure of Leveraged Loans
In-spite of leveraged loans being made (mostly) to companies with a credit rating in the junk area, i.e. below BBB-/Baa3, they are getting much attraction/love from investors this year. There are five reasons driving this theme:
- Senior status. Refers to type of debts that have priority over other unsecured-junior types of debts owed by an issuer. Senior debt has greater seniority along the capital structure of an issuer than subordinated debt.
- Secured status. Refers to type of debts that are guaranteed by a specific collateral - an asset which is pledged to secure the loan and can be taken by the lender should the borrower default. Secured debt benefits from greater protection compared to non-secured debt.
- Floating-rate feature. The interest rates move in tandem the benchmark interest rates, e.g. 1- or 3-month LIBOR rates, thus insulating loans from rate increases by the Fed.
- Short duration. The reset of the interest rates every 1-3 months make leveraged loans an extremely short-duration type of debt.
- High interest rates. When rates and yields are still historically low - the (usually) double-digit rates/yields on leveraged loans are hard to resist.
Floating-Rate ≠ Inflation-Protected
According to the Wall Street Journal, while stocks and bonds have been pulled down by concern over interest rates, leveraged loans have increased to $1.2T this year, exceeding the amount of outstanding junk bonds for the first time.
It's important to remember that there's a significant difference between a floating-rate to an inflation-protected feature. While the former protects against rising rates, the latter aims at protecting investors against rising inflation. This year demonstrates how distant the two features (that allegedly supposed to move in tandem) can be from each other.
Unlike fixed-rate US government bonds (SHV, SHY, IEF, TLT), Treasury inflation-protected (aka "TIP") debts (TIP, SCHP, VTIP, STIP) usually rise in value along with interest rates. Nonetheless, this year, they have actually declined because there has been little change in inflation expectations even as the Fed keep hiking rates.
Outperforming as Interest Rates Rise
The leading ETF among the leveraged loans arena is the Invesco Senior Loan ETF (BKLN). Investors should be quite pleased with its performance so far this year compared to other asset classes.
- iShares iBoxx $ Invmt Grade Corp Bd ETF (LQD); BKLN is outperforming by 8.26%
- iShares Core US Aggregate Bond ETF (AGG); BKLN is outperforming by 5.64%
- iShares TIPS Bond ETF (TIP); BKLN is outperforming by 5.52%
- iShares iBoxx $ High Yield Corp Bd ETF (HYG); BKLN is outperforming by 2.86%
- SPDR® Blmbg Barclays High Yield Bd ETF (JNK); BKLN is outperforming by 3.70%
- SPDR® S&P 500 ETF (SPY); BKLN is outperforming by 1.68%
Interestingly though, over the past three months, the BKLN ETF is significantly outperforming senior loans Closed-End Funds ("CEFs"), e.g. Blackstone/GSO Strategic Credit (BGB), Blackstone/GSO LS Credit Income (BGX), Ares Dynamic Credit Allocation Fund (ARDC), Oxford Lane Capital Corp (OXLC)*, and Eagle Point Credit Co LLC (ECC)*
*Publicly-traded registered closed-end management investment companies specializing in Collateralized Loan Obligation (" CLO") vehicles.
Having said that, on a longer time frame (2-3 years or more), these CEFs are performing better than the competing ETFs.
Under-performing the Benchmark
Nonetheless, just as we have claimed recently about equity REITs (VNQ, SCHH, IYR, XLRE, RWR, ICF), there are certain segments/sectors where one is likely to do better using a Do It Yourself ("DIY") approach rather using an ETF.
In spite of its 2018 outperformance (thus far), BKLN has underperformed an index of leveraged loans by nearly one full percentage point so far this year, continuing its steady underperformance (against this index) since inception.
This raises questions about the ability of ETFs to track indexes of harder-to-trade assets, just like leveraged loans are.
Higher Risk/Volatility = Higher Spreads
The number of significant moves (>1% between two consecutive days closing prices) and/or daily swings (>2% between low to high) in the equity market, this month, has been rarely seen since the global financial crisis 10 years ago.
As we are heading into the last trading day of October, the S&P 500 index is off by 7.9% this month, on pace for the worst monthly performance since May 2010.
Nevertheless, in the larger context, the index is still up circa 29% since the US elections took place, almost two years ago.
Although reported earnings growth for Q3/2018 has been robust and in spite of economic growth remaining strong, credit spreads in the corporate bond market continue to widen, as investors are (finally) requiring greater compensation for the (higher) risk they are taking.
Based on the Morningstar Corporate Bond Index (a proxy for the investment-grade market), the average spread has widened to +121 bps.
According to BofA Merrill Lynch High Yield Master Index (a proxy for the junk market), the average spread has widened to +385 bps.
There are signs that investor demand for leveraged loans is starting to cool off. BKLN, the biggest US ETF focused on this asset class, just had its largest one-day outflow, in its entire history, last Friday (10/26/2018).
Volatility (VXX) has re-emerged not only across equity markets but also among credit markets, causing significant fund outflows in the high-yield sector (as a whole) too.
This is especially true when it comes to institutional or fast-money accounts that are looking to quickly adjust and reduce exposure to risky asset classes as soon as any hint of trouble arises.
Net HY fund outflows have totaled ~$2.5B last week, out of which, ETFs (a proxy for institutional investors) accounted for ~$1.9B and open-end funds (a proxy for individual investors) accounted to ~$0.7B.
On a YTD basis, total HY fund outflows amount to $21B (!), out of which, open-end funds account for $13.8B while ETFs account for $7.2B.
Leveraged loan valuations may have already peaked.
Corporate bond investors are already requiring wider spreads on risky debts to compensate for the rising risk/volatility.
Furthermore, massive outflows (both last week and YTD) clearly point out that the segment is losing its attraction.
It'll be interesting to watch by how much loan ETFs may underperform the broader loan indices going forward. If they continue to lag, this may be an indication of how they may perform in a truly down market.
We believe that while leveraged loans may continue to provide positive total returns over months to come, the risk/reward profile here is becoming stretched and leveraged loans are likely to lose their allure and fade away along 2019.
What we certainly don't expect is for this segment to keep delivering the double-digit total returns (per annum) investors got used to see over the past 2.5 years (below chart starts on 02/16/2016).
Make sure you get off this train before the last station!
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Disclosure: I am/we are long BGB, BGX, ARDC, OXLC. 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.