Similarly, with senior loans, when the markets have been smooth and stable, they have not broken any land speed records in terms of upside returns, but they have generated relatively high income from their coupons. Senior loans are also not dependent on rising interest rates to perform. However, when rates are rising, as they have been this year, senior loans will typically outperform most other fixed income asset classes because of their extremely short duration (and resulting lower interest rate risk). During periods of market volatility, such as what we’ve seen over the past few weeks, senior loans have historically held up and delivered their returns as designed.
Exhibit 1: Total Returns of Loans vs. Other Asset Classes
During the volatility that markets experienced in October, loans held their value better than other major asset classes.
|U.S. High Yield Bonds||-1.63%||0.84%|
|Investment Grade Bonds||-0.79%||-2.38%|
|Emerging Market Bonds||-2.16%||-5.13%|
|Emerging Market Stocks||-8.70%||-15.51%|
|S&P 500 Index||-6.84%||3.00%|
Source: JP Morgan, as of 10/31/18. Senior loans are represented by the JP Morgan Leveraged Loan Index; U.S. High Yield Bonds, by the JP Morgan U.S. High Yield Index; U.S. Treasuries by the Bloomberg Barclays Treasury Index; Investment Grade Bonds, by the Bloomberg Barclays U.S. Aggregate Bond Index; Emerging Market Bonds, by the JP Morgan Emerging Market Bond Index Global; and Emerging Market Stocks, by the MSCI Emerging Markets Index.
Some Thoughts on the Recent Spate of Negative Articles on the Loan Asset Class
A number of recent articles in the media have sounded alarms about the loan market. The common theme goes something like this: “Because the loan market has been experiencing such strong demand, the credit quality of loans today is greatly diminished because of a rise in ‘cov-lite’ issuance.” (See our paper, “Corporate Loan Covenants in Perspective,” for an in-depth discussion of cov-lite loans.) Some other ancillary topics get sprinkled in, as well, such as “loan only” deals. These proclamations are misleading as they attempt to characterize something as deeply complex as credit analysis with just a few brushstrokes. Moreover, glaring in its omission in these articles is any mention of the very solid credit fundamentals of these loan issuers. Total average leverage is at manageable levels, average interest coverage is nearing a 10 year high, and default rates are tracking at very low levels of 1.7% YTD. Our team of investment professionals studies individual companies and their creditworthiness every day, and our view on, and outlook for, the loan market differs greatly from the media’s alarmist message.
Modern corporate lending is a complex business. A multitude of factors are considered prior to purchasing a senior loan, issues that go far beyond whether the covenant package is labeled cov-lite or not. Unfortunately for the reporters who would like to boil the complex topic of corporate lending down to one simple denominator, it is not possible to do so with any degree of accuracy. We believe that trends in cov-lite transactions are, at best, an extremely weak indicator of a deal’s quality. When performing bottom-up credit analysis, investment teams examine many different factors before making the decision on whether to invest. The value of the collateral that secures the loans, the cash flows, leverage, interest coverage, the issuing company’s management team, and the firm’s capital structure are examples of the numerous factors to consider.
Credit markets are classically cyclical and always will be. Both interest rates and the strength of covenant packages should be expected to ebb and flow with the supply of and demand for credit. Professionals involved in the business of lending day in and day out understand that a good loan is one that works for both the lender and the borrower. Borrowers need the freedom to operate and grow their business, and deal with their customers and suppliers through a variety of market conditions. Lenders need to have the requisite protections in place to be comfortable that their debt will be serviced and repaid upon maturity. Clamoring for covenants appropriate for recessionary times during expansionary market conditions is neither productive nor realistic. Correspondingly, not having recessionary style covenants during expansionary times should not be construed to mean the loan market is either in an unhealthy state or headed for a fall.
Conclusion: Senior Loans Warrant Consideration as a Core Fixed Income Holding
Just like SUVs, which are designed to perform well in many different driving conditions, loans are well suited, in our view, to perform in many different market environments, and they deserve to have a core piece of real estate within a fixed income portfolio. They deliver high potential income with capital preservation, and they do not have interest-rate risk.
The Bloomberg Barclays U.S. Aggregate Bond Index is an index of U.S. dollar denominated, investment-grade U.S. corporate, government and mortgage-backed securities.
The JPMorgan Leveraged Loan Index tracks the performance of U.S. dollar denominated senior floating rate bank loans.
The JPMorgan U.S. High Yield Index is an unmanaged index of high yield fixed income securities issued by developed countries.
The Bloomberg Barclays U.S. Treasury Index measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury.
The JPMorgan Emerging Market Bond Index Global is a composite index representing an unleveraged investment in emerging market bonds that is broadly based across the spectrum of emerging market bonds and includes reinvestment of income (to represent real assets).
The MSCI Emerging Markets Index is designed to measure equity market performance of emerging markets.
The S&P 500® Index is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries within the U.S. economy. The index includes reinvestment of dividends but does not include fees, expenses, or taxes.
Indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict performance of the Fund. Past performance does not guarantee future results.
Duration measures interest rate sensitivity. The longer the duration, the greater the expected volatility as rates change.
Mutual funds and exchange traded funds are subject to market risk and volatility. Shares may gain or lose value.
Short-term interest rates and longer-term Treasury rates may or may not move in tandem directionally or in magnitude.
Senior loans are typically lower rated and may be illiquid investments (which may not have a ready market). Fixed income investing entails credit and interest rate risks. When interest rates rise, bond prices generally fall, and a fund’s share price can fall. Derivative instruments entail higher volatility and risk of loss compared to traditional stock or bond investments.
These views represent the opinions of the authors 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.