What has been arguably the most popular strategy within the non-investment grade market over the last year and a half is investing in floating rate loans. Because these are floating rate securities, there has been a massive interest in this space by those concerned about higher rates. The demand for and expansion in the loan market can’t be described in any way other than astounding. We saw .4 billion flow into bank loan exchange traded and mutual funds in 2013. This compares to the previous annual record of .9 billion in 2010.1 We saw a record 9 billion in bank loans issued in 2013. This handily beats the prior record high of 8 billion seen in 2007.2 And just to verify it has been a one-way trade over the last year and a half, we’ve seen 84 consecutive weeks of inflows into bank loan mutual funds and ETFs.
At face value this seems like a “no brainer” trade, and many have embraced it as such, but the actual numbers tell a bit of a different story. In 2013, floating rate loans returned 5.3% versus 8.2% for high yield bonds.3 This has been in a year when the 10-year Treasury yield had increased over 130bps. It would seem that if floating rate loans are really the answer to rising rates, we would have seen a better return, especially given the massive inflows into the asset class. And even with the 10-year Treasury yield increasing by over 1.3% (or over 50% from the beginning of year yield), the high yield market, helped by higher initial starting yields, still well outperformed the loan market over 2013.
The first consideration when investing in the loan market must be understanding to what the “floating” rate is tied. Bank loans are generally based on short-term LIBOR rates, which have moved very little this past year despite the big moves we have seen in various Treasury rates.
Additionally, many if not most loans have LIBOR floors, generally ranging from 1-1.5%, meaning we would need to see a substantial rise in short-term LIBOR rates before there was any impact on the coupon paid on the loan.
An investor should also keep in mind that with all of the money flowing into the loan asset class and chasing securities over the last couple years, there are now many overvalued names in the space. This has left a vast majority of the market priced around or above par, and with little in the way of call premiums offered in this market, there also appears minimal potential for further price appreciation for many of these loans. Finally, the general perception seems to be that loans are always less risky than bonds. However the reality is that many companies have debt financing that consists entirely of loans and some of those loans are still part of capital structures that are very highly levered.
At the end of the day, a loan investor may be left with a security that has a low starting yield, little left in the way of capital gains potential, and with coupon income that is not at all increasing even if rates were to rise. While there are some selective opportunities for value in the loan space, broadly speaking we see high yield bonds as a more attractive market in the current environment.
1 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Leveraged Loan Market Monitor,” J.P. Morgan North American High Yield and Leveraged Loan Research, January 2, p. 9.
2 Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Leveraged Loan Market Monitor,” J.P. Morgan North American High Yield and Leveraged Loan Research, January 2, p. 1.
3Acciavatti, Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Leveraged Loan Market Monitor,” J.P. Morgan North American High Yield and Leveraged Loan Research, January 2, p. 1.
4 Data as of 12/31/13, sourced from Bloomberg.