The Evergreen Case
The long-term case for senior loans is evergreen. Over the past 27 years, the senior loan market has generated positive total returns in 26 of them. Over this timespan, there were different interest rate environments and full credit cycles, and yet senior loans held up quite well throughout most of these diverse conditions. The most recent case in point: year-to-date the loan market has generated a positive total return of 5.61% despite a drop of 22 basis points (bps) in the U.S. Treasury 10-year yield. This is a result of senior loans’ unique characteristics of historically generating relatively high income, typically having very low interest rate sensitivity, ranking senior in priority in an issuer’s capital structure, and being secured by the assets of the issuer. The primary risk with senior loans is purely credit risk, and because defaults have historically been very low (with the long-term average less than 3%), the attractive attributes of the asset class generally enable it to navigate successfully in most market environments.
However, unlike bonds, senior loans have no call protection. They are callable at par at any time. As a result, their normal trading range is 98-100, and never much above that. Hence, 99% of their total return over the long term comes from their high coupon. It is uncommon to expect and receive additional return from any price appreciation unless the loans are available at a discount.
The Relative Value Opportunity Now
Currently the average price of the senior loan market remains suppressed at about 96.5, below the average range of 98-100. Only 16% of the senior loans in the asset class’ major index are currently trading at or near 100. That low level compares to over 80% a year ago. Exhibit 1
As illustrated in Exhibit 2, the average historical spread between senior loans and high-yield bonds is 110 bps. However, today the credit spread of the senior loan market is now greater than that of the high yield market by about 20 bps to 30 bps. That means the spread right now between senior loans and high yield is inverted. Investors are getting paid less for being in a lower credit quality asset class.
Let’s explore why that is and discuss what we view as the subsequent opportunity.
Follow the Money – the Answer Can Be Found in the Flows
The opposite direction of retail flows between senior loans and high-yield bonds tells the story. Exhibit 3 The senior loan market has had $13 billion in retail outflows year-to-date, while the high-yield market has taken in $15 billion of retail inflows. Greater investor demand for high yield has caused credit spreads in the market to tighten, while lower demand for senior loans has had the opposite effect.
Since the beginning of this year, the U.S. Federal Reserve has reversed its posture from a tightening stance, which it had as recently as the fourth quarter of 2018, to now signaling one or more potential interest rate cuts this year. A meaningful portion of the retail investor base views the senior loan asset class as simply a tactical interest rate play, to be purchased only in a rising interest rate environment. In our opinion, the flaw in that limited view is the dismissal of the importance and value of the other attractive attributes that loans have the potential to deliver high income and senior secured positioning in the capital structure. That distinct combination historically has produced a favorable risk-adjusted return profile relative to many other major asset classes. Exhibit 4
Senior Loans Are Pure Credit Risk
We spent much of this piece describing the opportunity today from the dislocation in senior loan valuations because of a technical imbalance. We find valuations of senior loans to be attractive today, and certainly in comparison to other lower quality asset classes such as high-yield bonds. However, at the end of the day what matters most to professional senior loan investors is the associated credit risk of a given loan. Will an issuer be able to support its debt, pay its coupons, and pay off the loan at maturity? Bottom-up fundamental credit analysis is critical in determining the risks, the downside, the asset coverage, and the return of each individual loan. It is a deep and thorough analysis that considers a whole host of factors, including the value of the assets securing the loans, covenants, cash flows, credit statistics (such as total leverage, interest coverage, and defaults) and management teams, among many other considerations.
Credit Quality Snapshot Today
We would characterize the overall credit quality of the senior loan market now as generally solid. Full U.S. employment, modest gross domestic product (GDP) growth, positive corporate earnings with top- and bottom-line growth, decreasing leverage, and below average default rates all support this benign outlook.
While we try to discourage investors from tactically timing the senior loan market simply on the basis of interest rate direction, we do see an unusually attractive opportunity today in which investors can seek to take advantage of a temporary technical dislocation between senior loans and high-yield bonds by moving up in credit quality without giving up the potential for yield. We expect this relative value dislocation will eventually correct once rates stabilize, and as lighter new issue supply finds balance with the current level of demand.
In the meantime, we believe there is a compelling case to be made that, in addition to the evergreen case for loans, investors can now move up in credit quality from junior to senior priority and from unsecured to secured status without giving up yield. Senior loans are currently yielding close to 6% and there is the potential for another few points of additional return from price appreciation. In our view, combining that with solid credit fundamentals makes a strong case for the merits of revisiting senior loans.
The Credit Suisse Leveraged Loan Index tracks the investable market of the U.S. dollar denominated leveraged loan market. It consists of issues rated “5B” or lower, meaning that the highest rated issues included in this index are Moody’s/S&P ratings of Baa1/BB+ or Ba1/BBB+. All loans are funded term loans with a tenor of at least one year and are made by issuers domiciled in developed countries.
The Credit Suisse Leveraged Loan Index tracks the investable market of the U.S. dollar denominated leveraged loan market.
The J.P. Morgan Leveraged Loan Index tracks the performance of U.S. dollar denominated senior floating rate bank loans.
The J.P. Morgan Global High Yield Index consists of fixed income securities of domestic and foreign issuers with a maximum credit rating of BB+ or Ba1.
The Bloomberg Barclays Aggregate U.S. Treasuries Index represents 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 an index of U.S. Government and corporate bonds that includes reinvestment of dividends.
The S&P 500 Index is a market-capitalization-weighted index of the 500 largest domestic U.S. stocks.
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.
Sharpe ratio is a measure that indicates the average return minus the risk-free return divided by the standard deviation of return on an investment.
Par is the face value of a senior loan.
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 any Oppenheimer fund. Past performance does not guarantee future results.
Mutual funds and exchange traded funds are subject to market risk and volatility. Shares may gain or lose value.
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 portfolio manager 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. These views represent the opinions of 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.