With volatility returning to the markets, some investors are seeking diversification and downside protection in the leveraged loan market. The unique nature of loans – floating rate, secured debt instruments at the top of the corporate capital structure – affords a hedge against rising rates and may provide principal protection if economic conditions worsen. Chief Investment Officer Global Credit Mark Kiesel, portfolio manager Beth MacLean and product manager Rudy Pimentel discuss why they see value in loans, PIMCO’s approach to credit selection and risk management in bank loan portfolios, and the many ways loans can play a role in an investor’s portfolio.
Q: Mark, you have been adding loans to many of the portfolios that you manage – what makes them attractive to you and your team?
Kiesel: We have been adding loans for three main reasons: They have limited interest rate risk and short effective maturities, they often provide good downside protection and they offer compelling value today.
First, as floating rate instruments, loans allow us to take “pure” credit risk – this is, without the interest rate or duration risk we see in investment grade and high yield corporate bonds. In a rising rate environment, a loan’s coupon rises as rates rise. Of course, the reverse is true when rates fall.
Loans also tend to have shorter maturities than those of most corporate bonds. A newly issued loan typically has a maturity of five to seven years, compared with 10 years for a traditional high yield bond and up to 30 years for an investment grade bond. What’s more, because loans are callable and usually include some amortization and required payments from the issuer’s excess cash flows, their average life is usually less than three years.
Second, loans are secured by the assets of the company issuing the debt and are senior in its capital structure. That means loans generally have the highest priority and degree of principal protection if the issuer defaults. Thus, a company’s loans tend to perform better than its bonds in periods of economic stress when corporate defaults begin to rise.
Finally, with spreads, or yield premiums over Treasury bonds, that are similar to those of high yield bonds, loans look very compelling on a relative basis. And with recent yields for the JPMorgan Leveraged Loan Index at 5.85% as of 16 October 2014, we find them attractive on an absolute basis also.
So loans offer compelling value, they help reduce interest rate and credit risk when compared with similar corporate bonds and their unique characteristics may provide diversification benefits for client portfolios. This is why we ask: Got loans?
Q: Beth, describe your investment process – what sets PIMCO apart in the loan business?
MacLean: 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, providing a framework for credit selection that is underpinned by our deep knowledge of industries and companies. Furthermore, our research process and active monitoring of portfolio positions help us avoid credits whose fundamentals could deteriorate if economic conditions worsen or a number of company-specific risks materialize. We don’t reach for yield; we believe that paying attention to both credit fundamentals and valuations helps us maximize returns for our clients over the full credit cycle.
While each portfolio has unique guidelines reflecting specific client objectives and risk tolerances, our investment strategy has always emphasized careful credit selection and downside protection. We focus on the larger corporate issuers, companies with high barriers to entry and robust capital structures, with bonds beneath the loan and a strong equity valuation as well. These larger cap companies – compared with the growing number of smaller, middle market issuers that have come to market this year – are leaders in their industry, giving them structural advantages and more financial flexibility than smaller market participants. And we also favor more defensive sectors, like healthcare, or those with steady cash flows, like cable television. (See our Global Credit Perspectives, “Emphasize Barriers to Entry,” September 2014.)
The portfolios we manage are highly diversified across issuers and industries, and our credit philosophy aims to position our clients’ assets in the credits that can withstand the most challenging parts of economic and credit cycles. Further, because we focus on larger cap, more liquid issuers, we may experience above-average liquidity in the market, compared with others who follow a broader index strategy, which would include smaller, illiquid loans.
Q: Beth, where do you think we are in the credit cycle today?
MacLean: Well, I am a hockey fan, so I would say we are in the second period – they still have to clear the ice and play another 20 minutes before we see a change in the cycle. Credit fundamentals remain strong, with corporate issuers having benefitted from years of profit growth and open capital markets – both of which have allowed them to deleverage and to shift maturities out several years. While overall leverage has been rising modestly in recent transactions, cash flow coverage generally remains strong, given the low rate environment. Defaults are low, and with global central banks remaining highly accommodative to support recovery in the private sector, we expect them to remain low at 2%–3% per year for the next couple of years.
With this strong fundamental backdrop, any market volatility that is driven by supply, demand or exogenous events should provide opportunities to buy select loans at attractive prices.
Q: So, what has driven the recent price volatility in the credit markets?
MacLean: It really is all about the “technicals” – a catch-all term for anything not related to credit fundamentals. This year, volatility in the loan market has been led by the high yield market (see our October 2014 Viewpoint, “We Don’t Call It Junk Anymore: Time to Look at High Yield Again”). Both early in the summer and in recent weeks, outflows from high yield funds fueled a high yield market correction that quickly spilled over to the loan markets. As we have seen in past technical corrections, often the larger, higher quality loans are the first to be sold since they are used to raise cash for redemptions. Counterintuitively, they tend to underperform in the early parts of a selloff. However, in an extended risk-off environment, we would expect these loans to outperform the lower quality, higher beta names.
Additional technical pressure today arises from the new issue calendar. Although we are already nearing record issuance, we saw a surge in new issue activity in September and at least $20 billion in additional issuance remains in the pipeline. This heavy supply will likely lead to more attractive prices for these new issues and the rest of the market.
On the positive side, however, collateralized loan obligation (CLO) issuance remains very strong, so there remains a natural bid, both for new issues and for loans trading in the secondary market. And in technically driven market corrections, we often see institutional investors step in to take advantage of attractive valuations. CLOs have been an important source of demand in the market, and even with more strict risk retention rules just announced under Dodd Frank, we think the near-term impact will be for continued strong demand from a pull-forward effect before the rules are implemented, which will not be for two years. Longer term, larger managers with access to capital from private equity or insurance company parents, for example, will still be able to issue CLOs. We are also likely to see new companies formed – partnerships of hedge funds and CLO managers, perhaps – that may be able to issue CLOs under the new rules. Finally, there are already alternatives to CLOs in credit opportunity funds and other funds that use leverage, and I expect that we will see more of this type of vehicle established as these new rules come into effect.
Q: Rudy, what types of investors are buying loans today?
Pimentel: The short answer is that most are, from individual investors to large corporations. While each has unique investment goals and objectives, they typically invest in loans to minimize risk within their credit allocation – interest rate risk, credit risk or both – without giving up much current income. Some recognize that a long-term strategic allocation to loans can have meaningful diversification benefits.
Individual and institutional investors have added loans to their portfolios in recent years through mutual funds, whose collective assets have grown to $140 billion and now make up nearly 20% of the loan market. Much has been written about recent outflows from loan mutual funds. However, we view this as part of the natural rebalancing of investors’ portfolios and a byproduct of the large inflows the industry experienced in the preceding years. So far this year loan funds have experienced outflows representing less than 10% of assets, which compares with inflows in 2013 representing 75% of assets. Historically, we have seen mutual fund investors add exposure when they become concerned about the risk of rising interest rates, so we could see mutual fund inflows again next year if the Federal Reserve begins its rate hiking cycle.
Pension funds, insurance companies, banks and, to a lesser degree, endowments, foundations and sovereign wealth funds have also been increasing their exposure to loans. These investors may use loans as part of their high yield allocation, or as a strategic investment. Some establish separately managed accounts, which enable them to tailor the investment guidelines to their risk tolerance and specific investment objectives.
We have worked with many investors with higher risk tolerances to apply two to three turns of leverage to loan portfolios to seek enhanced returns. Leverage can amplify risks as well as returns so we don’t typically leverage credit exposure in our loan mutual funds. And while PIMCO’s New Neutral thesis sees lower rates for longer, it also posits that when the Fed does eventually raise the fed funds rate, it will do so gradually and only to around 2%. This suggests that if used prudently, leverage can be an effective tool in some investors’ toolkits, particularly as global central banks remain accommodative and the economy continues to heal.
And finally, as Beth mentioned, CLOs remain an important vehicle for a subset of institutional investors to take exposure to loans. While CLOs are highly leveraged structures, with many deals having 10 times more assets than equity, they offer investors a menu of risk and reward investment options – from AAA-rated debt to unrated, equity-like tranches.
PIMCO’s ability to offer different investment options allows our clients to choose vehicles that closely match their specific investment objectives and risk tolerances.
Q: Finally, Beth, we have to ask about the recent comments from the Fed regarding concerns over leveraged lending standards. What are your thoughts on the topic?
MacLean: Well, we covered this in depth in a piece earlier this year. Most recently, the Fed has criticized some banks for not following their leveraged lending guidelines, and we expect the Fed and other regulators will remain focused here. However, when questioned, New York Fed President William Dudley recently stated that he did not believe the leveraged loan market poses any systemic risk, and Fed Vice Chairman Stanley Fischer earlier this year remarked that the loan market was “not big.” So Fed members themselves do not appear concerned about loans having a major impact on financial stability.
To us, the Fed’s guidelines seem too blunt a tool, with a one-size-fits-all approach that does not really work across a diverse universe of issuers. But there are some very aggressive deals being printed today and some market practices with which we strongly disagree. That underscores why PIMCO’s investment approach, with careful, bottom-up credit selection and active monitoring of portfolios, is so important.
Further, given our size in the market, strong credit research team, focus on high barriers to entry, defensive positioning and diverse portfolios, we believe our client portfolios are well positioned to weather episodes of market volatility. A move to senior secured floating rate loans could be a solution for select investors looking to reposition portfolios.