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Elizabeth (Beth) MacLean
The unique nature of bank loans has made them increasingly attractive to investors who are searching for income or concerned about rising rates. Portfolio manager Beth MacLean discusses the state of the bank loan market, PIMCO’s approach to targeting value and managing risk, and the multiple roles bank loans can play in a portfolio.
Q: What is driving the significant investor interest in bank loans? Beth MacLean: I think the attraction to bank loans today is due to three key goals pursued by many investors – principal protection, short duration and interest rate protection.
First, bank loans are senior secured loans to non-investment-grade corporations. The loans are secured by the collateral of that company and are senior in the capital structure, meaning they take highest priority in the event of a restructuring. Second, loans are shorter in maturity than a typical high yield bond and are also callable, so they tend to be shorter duration than their bond counterparts. A typical loan maturity is five to seven years, vs. 10 years in a high yield bond; what’s more, because they are callable and usually include some amortization and required payments from the issuer’s excess cash flows, the average life of a loan is usually less than three years. Finally, loans are a floating rate instrument. Unlike a fixed-rate bond, bank loans offer a spread over the London Interbank Offered Rate, or LIBOR. So, in a rising rate environment, the “all-in” coupon, or the combined LIBOR rate plus the spread, rises as rates rise. Of course, the reverse is true when rates fall. It’s also important to note that there are credit risks associated with bank loans; they may also have similar liquidity risks to high yield bonds.
These features are currently very attractive to investors, many of whom are challenged to find income in today’s low yield environment and may also be concerned about rising rates down the line. Investors are being pushed out the risk spectrum by central bank actions and by diminishing returns in other areas of the fixed income markets. Bank loans are a more defensive way for investors to move into the high yield space, due to the collateral and their senior position. And, while PIMCO doesn’t believe a policy rate rise is imminent by any stretch, if we do get to a point where that happens, the underlying coupons of bank loans will rise as well. They are really the only fixed income asset class with virtually no interest rate sensitivity, which is a negative when interest rates are decreasing, but can be very beneficial when the rates do rise.
The unique characteristics of loans offer another key benefit, in that they typically have low correlations to other fixed income assets such as Treasuries and investment-grade bonds, and only a moderate correlation to equities.1 They have also had a very high correlation to inflation.2 As a result, banks loans have historically been good diversifiers in an overall portfolio. It’s important to note, however, that diversification does not guarantee against loss.
Taken together, the attractiveness of these features has translated into heavy inflows into loan-focused retail funds.
Q: Are valuations on bank loans still attractive? What has been the impact of the recent wave of repricings in this market? MacLean: In terms of valuations, we have seen yield spreads tightening among loans, but that has been true across the fixed income markets, particularly in high yield. So on a relative basis we do think loan valuations still look attractive. That’s true on an absolute basis as well, as markets have not sufficiently priced in the extremely low default rates, which are only about 1.4%.3 As a result, investors are earning excess spreads versus default loss expectations, that, even after the recent repricing wave, remain better than those in the market before the 2008 financial crisis.
But repricings have had an impact. Bank loan issuers typically have the option of calling their debt. They can do so at any time, although there may be a penalty for doing so in the first year. Therefore, when access to credit markets is favorable, issuers often attempt to lower their borrowing costs by calling existing debt and offering new loans with similar terms, but at a lower financing cost. That has certainly been the case recently, given the strong demand for bank loans. As an example, BB-rated loans issued a year ago provided a yield of about 5%; today, that same loan can be replaced at a yield of about 3.7%.4 So investors are definitely earning less, but again, we’re seeing that in other fixed income areas as well; BB-rated bonds are yielding 4.5% or even less.5
The bright spot of this trend, however, is that it points to the fundamental strength of the underlying credits. Companies are able to execute at tighter levels in the market today for a number of reasons: the strength of corporate balance sheets; leverage levels in the market overall that remain below precrisis levels; stronger interest coverage as companies benefit from the low rate environment; and maturities on loans and high yield debt that have been pushed out through active amendments, extensions and refinancings over the past several years. These fundamental strengths in the underlying credits should continue to support a low default environment. Thus, as long as we remain confident in the strong fundamentals and our outlook on a specific credit is very positive, we may be willing to accept a lower yield.
While the current yield environment can add risk, PIMCO’s investment process and portfolio management are uniquely designed to reduce potential threats. Our approach combines PIMCO’s long-term macroeconomic outlook with careful bottom-up, fundamental research, which develops a framework for positioning that is underpinned by our deep knowledge of sectors, industries and companies. Furthermore, our research process and active monitoring of portfolio positions helps us avoid credits that have deteriorating fundamentals and are at risk if the macroeconomic situation worsens. Ultimately, we believe that paying attention to both credit fundamentals and valuations helps us maximize returns for our clients over the full credit cycle.
Q: How do you assess the risks of “covenant-lite” loans? MacLean: Since the financial crisis, there has been a marked increase in the issuance of loans that have fewer covenants, or restrictions, on the issuer, often with terms that are more similar to a traditional high yield bond. These covenant-lite loans, as they’re known, still have some – albeit weaker – covenants built into them. For example, they generally include incurrence tests, which restrict the amount of leverage a company can use when it wants to issue new debt, but they may no longer include maintenance covenants, which cap leverage at specified levels on an ongoing basis.
For investors, the reduction in maintenance covenants means that they really need to evaluate and understand a company’s fundamentals, both before and after buying the loan. Fortunately, bottom-up research is one of PIMCO’s strengths and is embedded into our investment process. Our research team closely examines every new loan we consider, building our own projection models and forecasts of how that company will deleverage over time and setting deleveraging targets that we monitor internally. So in effect, we do our own maintenance testing. We also look at the issuer as a whole, focusing on the entire capital structure to make sure we have a broad view of a company’s balance sheet. In a restructuring, the capital structure – the equity and unsecured or subordinated debt behind the loan – will be most critical to the ultimate value or recovery to the secured lenders.
Q: What is PIMCO’s outlook on interest rates and how could bank loans be affected? MacLean: We believe that interest rates are going to remain very low through at least 2015. The Federal Reserve and other central banks have committed to quantitative easing and other stimulative measures until economic growth has gained a firm footing – something we don’t expect for the developed markets for some time. However, there are a few important points related to bank loans in that regard. One is that although central bank action has kept LIBOR artificially low, below 1% since 2009, most new loans in the market have a LIBOR floor that averages just over 1%.6 The other point is that as rates rise (and once LIBOR surpasses the floor), loans will benefit as their coupon resets in line with those increases. This is very different from other fixed income asset classes, of course, which are subject to interest rate sensitivity, particularly at longer maturities.
There’s also a corollary to a rising inflation environment. If the economy is overheating, it means companies are doing well, which will compress the yield spread on the companies issuing the loan. At the same time, the Federal Reserve will try to increase rates to cool the economy and LIBOR will likely increase as well – causing the loan coupon to reset. These two facts – that loan coupons reset with changes in LIBOR rates, as well as the inverse relationship between rates and credit spreads – have historically provided for the strong performance of loans in an inflationary environment.7
Q: Finally, how can investors gain access to this market? MacLean: The loan market is still technically a private market. Because loans are not securities, individual investors cannot buy individual loans. Many individuals participate through mutual funds or managed accounts that focus on bank loans, working with an active investment manager, with expertise in this market, such as PIMCO. We think there are decided investor benefits to accessing loans this way, among them experienced active management, tested risk controls, a research infrastructure and a diverse portfolio reflecting that manager’s best investment ideas.
1 As of 31 March 2013, based on monthly correlation figures for returns since January 1995. Bank loans are represented by Credit Suisse Leveraged Loan Index returns, U.S. Treasuries are represented by returns on five and 10 year on-the-run, investment grade bonds are represented by returns on Barclays U.S. Credit Index, equities are represented by S&P 500 returns.
2 As of 31 March 2013, bank loan correlation to CPI was 0.48. Based on quarterly returns on Credit Suisse Leveraged Loan Index since 1997representing bank loans.
3 Source: May 2013 rolling twelve-month par-weighted default rate from J.P. Morgan.
4 Source: S&P LCD, as of 30 May 2013.
5 As of 30 May 2013. Source: Merrill Lynch BofA BB Constrained Index, yield to worst.
6 Source: 104 bps according to S&P LCD on 30 May 2013
7 Based on Credit Suisse Institutional Leveraged Loan Index. Since 1997, during five periods of interest rate increases bank loans had the following annualized performance: 9/98-1/00: 6.3%, 10/01-3/02: 3.1%, 9/02 – 6/06: 6.0%, 12/08 – 12/09: 12.3%, 08/10 – 03/11: 6.3%.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their financial advisor prior to making an investment decision.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2013, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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