Rising rates and the case for leveraged loans
By Mark Boyadjian, CFA Senior Vice President, Director, Floating Rate Debt Group, Franklin Templeton Fixed Income Group
By Reema Agarwal, CFA Vice President, Director of Research, Floating Rate Debt Group, Franklin Templeton Fixed Income Group
For certain investors—in particular pension funds and insurance companies that tend to follow a more cautious investment strategy—the extended period of record or near-record low US interest rates has been a thorn in the side. Many such institutions rely on investment returns to meet commitments or drive profitability and have been beleaguered by the low yields inherent in the current environment.
As a result of a search for yield among such constituents, some of these institutions have been looking at asset classes outside conservative low-yielding government and corporate bonds. One of these has been leveraged loans or bank loans, which offer the potential to provide a fairly attractive level of income with minimal interest-rate risk, because the coupon adjusts. For example, at the end of 2014, the Credit Suisse Leveraged Loan Index had an average coupon greater than 4.75%, duration positioning of less than 0.25 years, and an average dollar price below par.
Floating rate debt market
The floating-rate debt market consists of below-investment-grade credit quality loans that are arranged by banks and other financial institutions to help companies, to, among other things, finance acquisitions, recapitalizations or other highly leveraged transactions. Although leveraged loans are considered below investment grade in credit quality, typically their “senior” and “secured” status can provide investors and lenders a degree of potential credit risk protection.
Floating-rate debt goes by many names which can be used interchangeably, including: leveraged loans, bank loans, syndicated leveraged loans and floating-rate bank loans.
We believe concern regarding anticipated increases in US interest rates is going to continue to have implications for fixed-rate and floating-rate assets. In that context, our view is that fixed-rate assets—particularly those with a duration of five years or shorter—may be experiencing material principal declines as a result of the interest-rate risk they possess.
While our outlook for the corporate credit market generally is positive for the balance of this year, we’re growing increasingly concerned about the potential credit risks that could develop in 2016 and 2017. Our concerns stem from the sense that floating-rate debt, like many asset classes, is sensitive to the laws of demand and supply.
In the context of rising rates, we believe many investors will seek to shed their duration and flock to assets that they perceive as having yield without duration, which may include leveraged loans.
Bank loans may offer a few key characteristics that may look attractive to many investors within the context of a rising rate environment.
- The duration on a leveraged loan is typically very low. If interest rates rise, price sensitivity is generally much less relative to a high-yield bond alternative.
- Leveraged loans are considered below-investment-grade in credit quality, but their “senior” and “secured” status can provide investors/lenders a degree of potential credit risk protection.
- Historically, leveraged loans have had a relatively low or even negative correlation to traditional fixed income vehicles such as government bonds.
- The floating-rate feature in leveraged loans means that as short-term interest rates go up, the corresponding income on loans typically should go up as well.
Supply and demand
Interest rate dynamics can have important implications in terms of supply and demand for the asset class. Traditionally, leveraged loans have derived the majority of total return from income. The majority of that income is derived from the underlying benchmark; LIBOR (the London Interbank Offered Rate) is the benchmark for US dollar-denominated term loans. Euro-denominated loans use EURIBOR, a similar measure to LIBOR. LIBOR represents the average interest rate estimated by leading banks in London that the average leading bank would be charged if borrowing from other banks, and it tends to track movements in the US Federal Funds rate. As a result, LIBOR would be expected to rise as US interest rates rise. In a rising LIBOR environment, we expect the demand for leveraged loans as an asset class could likely exceed the supply.