Typically, with the senior loan asset class, the total return comes largely from the coupon payments. Since loans have historically suffered very few actual default losses, their long-term return has primarily been generated by their coupon, while their year-to-year price fluctuations have been driven by shifts in investor sentiment. Over time, those price changes have historically reverted to the mean. As a result, it has been rare to derive much, if any, total return from price appreciation with senior loans because they historically trade within a range of 98-100.1
However, today, senior loans present investors with a compelling value proposition that is not usually available in the asset class. Given the sell-off in the asset class during the fourth quarter of 2018, there is also now the potential for price appreciation in addition to what recently has been an attractive yield.
History shows that it has been common for a year of relatively weak returns to be followed by a year of strong performance.
Weak Years Have Often Been Followed by Strong Ones
Total returns of senior loans as measured by the JPMorgan Leveraged Loan Index
To recognize why this is the case, it’s important to first understand what happened in the senior loan market in 2018, and specifically in the fourth quarter. The short answer is there was a panic. There was a dramatic shift in investor sentiment driven by a number of macro factors which created a “risk-off” environment. Trade/tariff fears, uncertainty about U.S. Federal Reserve policy, concerns of a slowing economy, and a host of other variables all contributed to the heightened volatility in the broad market and that led to investor redemptions in risk assets, including senior loans.
Nearly all of the more than $17 billion of inflows that the category experienced for the year reversed and abruptly exited. Fundamentals for the asset class were strong leading up to that point and, in our view, continue to be solid now, but the technical supply and demand imbalance put downward pressure on senior loan prices, causing spreads to widen significantly. At the beginning of the fourth quarter, the average price of loans was 99. At year-end 2018, the average price had dropped to 94.5 and spreads widened by about 180 basis points (bps), going from +380 bps to +560 bps.
2019 Outlook: Strong Credit Fundamentals and Attractive Valuations
The senior loan market today feels very similar to the conditions we had in late 2015 and early 2016. In December of 2015, there was a significant “risk-off” market environment driven by a multitude of macro factors. The result was very similar in that senior loan prices fell dramatically because of a technical imbalance, and the average price of senior loans dropped, reaching a low 89 in Feb 2016. All through this period, the corporate fundamentals were strong with below average defaults of less than 2% and healthy credit statistics. So predictably, as volatility eased, the senior loan market snapped back abruptly to a more normalized trading range of 98-100, and that generated a 2016 total return of 9.80% for the JPMorgan Leveraged Loan Index.
At the moment, retail outflows appear to have eased, and that has restored a more balanced technical backdrop. Corporate fundamentals remain solid and valuations are very attractive.
As noted at the outset, over the long term, more than 99% of the total return from loans comes from the coupons. Today, the 3-month LIBOR rate is near 3%, and credit spreads are around more than 500 bps, a level that equates to a more than 8% potential return simply from the yield of senior loans. With the average price of loans at a discounted price of about 95, there is the potential for about an additional 4-5 points of return from price appreciation. Add all of that up, and we believe there could be very attractive return potential for loans in 2019.
Evergreen Case for Senior Loans
Senior loans are designed to deliver several distinct and attractive attributes to investors. Because of their relatively high coupons, they typically generate high income, and given their very short duration (0.25 years), they have minimal interest rate risk. It’s also important to note that senior loans rank senior in priority in companies’ capital structure, and they are secured by the assets of the company, thereby providing downside mitigation in the event of a default. Lastly, senior loans have low correlation to most other asset classes, and that makes them a good diversifier within an investor’s overall portfolio.
A Comment on Liquidity
A frequently asked question about the senior loan market is whether there is liquidity risk, particularly during times of elevated redemptions. A common misperception is that the longer settlement time for loan trades somehow negatively impacts their liquidity. In fact, the settlement times have no bearing on trade liquidity. A good illustration of how well the market functioned came in December 2018, a month that set a record for the largest monthly outflow. Loan mutual funds redeemed $15 billion in December, more than twice that of the previous worst month on record. This represented 10% of senior loan funds’ total assets under management. The senior loan market is now an estimated $1.2 trillion in size, and mutual funds only account for about 11% of the total market. The remaining 89% consists of many different institutional market participants and collateralized loan obligations (CLOs). Because of this broadly diverse investor base, the market functions normally with healthy two-way flows, even during periods such as last December. Despite the heavy outflows during that month, senior loan funds were easily able to meet their redemption requests.
- ^Senior loan and bond prices are expressed as a percentage of their face value. A loan or bond trading at 98-100 is trading at 98% to 100% of its face value.
The Bloomberg Barclays U.S. Treasury Index is composed of public obligations of the U.S. Treasury with a remaining maturity of one year or more. The Bloomberg Barclays U.S. Aggregate Bond Index is composed of U.S.-dollar-denominated, investment-grade U.S. corporate, government, and mortgage-backed securities.
The Credit Suisse Leveraged Loan Index tracks the performance of U.S. dollar denominated senior floating rate bank loans.
The JPMorgan Domestic High Yield Index that tracks the investable universe of the below-investment-grade bonds in the United States.
The MSCI EAFE (Europe, Australasia, Far East) Index is designed to measure developed market equity performance, excluding the U.S. and Canada.
The JPM Leveraged Loan Index is a composite of senior loan returns representing an unleveraged investment in senior loans that is broadly based across the spectrum of senior loans and includes reinvestment of income (to represent real assets).
The S&P 500 Index is a market capitalization-weighted index of the 500 largest domestic U.S. stocks.
The indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Fund or any Oppenheimer fund. Past performance does not guarantee future results.
The London InterBank Offered Rate (LIBOR) is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. It is a primary benchmark for short- term interest rates around the world.
Mean reversion is financial theory suggesting that asset prices and returns eventually return back to the long-run mean or average of the entire dataset. This mean or average can be the historical average of the price or return, or another relevant average such as the growth in the economy or the average return of an industry.
Duration measures interest rate sensitivity. The longer the duration, the greater the expected volatility as interest rates change.
Correlation expresses the strength of relationship between distribution of returns between two data series. Correlation is always between +1 and –1, with a correlation of +1 expressing a perfect correlation, meaning that the two series being compared behave exactly the same, a correlation of –1 meaning the two series behave exactly opposite and a correlation of zero meaning movements between the two series are random.
Mutual funds and exchange traded funds are subject to market risk and volatility. Shares may gain or lose value.
Fixed income investing entails credit and interest rate risks. When interest rates rise, bond prices generally fall, and a fund’s share prices can fall. Senior loans are subject to credit, interest rate and prepayment risk, are typically lower-rated and may be illiquid investments (which may not have a ready market).
Diversification does not guarantee profit or protect against loss.
These views represent the opinions the portfolio managers at OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.