Western Asset's bank loan portfolio management philosophy asserts that the integration of superior fundamental credit research, relative-value analysis, and proper risk management should generate outperformance over a market cycle. The Firm's investments for bank loan portfolios include the full spectrum of below investment-grade corporate issues, ranging from conservative to aggressive and varying by quality, issuer and subsector.
Market Review 1Q 2013
The S&P/LSTA Performing Loan Index generated a return of 2.22% in 1Q13. The Index has produced positive quarterly returns dating back to 3Q11, and positive monthly returns for the last 10 consecutive months. Over the quarter, the average price of a loan in the market increased by $1.39 to a post-credit-crisis high of $98.67. Over 80% of loans in the market are trading above par. The economic recovery continued during 1Q13 despite the headwinds of an increase in payroll taxes and sequester-driven fiscal tightening. The economy continued its languid recovery in 4Q12, as the final estimate for the annualized GDP growth rate over 4Q12 came in at 0.4%. While positive, this figure does not compare favorably with the 1.9%, 2.7% and 3.1% growth experienced in 1Q12, 2Q12 and 3Q12, respectively. Employment numbers also demonstrated improvement, with more people finding jobs and the number of people filing new claims for unemployment leveling off. The latest nonfarm payrolls report, covering March, was disappointing but the general trend remains positive. On the European front, we saw several events which threatened to stoke further volatility during 1Q13. In February, markets were caught off-guard when Italy's general elections appeared to descend into chaos, with no clear winner or obvious governing coalition. The final outcome of the election has yet to be determined. In March, the Troika (the European Commission, the European Central Bank and the IMF), as part of a rescue of banks in Cyprus, presented an arrangement that would place haircuts on all Cypriot bank deposits, including those that were supposedly insured. Even though this solution was ultimately scrapped, markets were bewildered and spooked that a plan that so blatantly subverts the purpose of deposit insurance would be considered as a template for future bank rescues. Overall, markets reacted positively and the spread-to-call (three-year call assumption) narrowed by 44 basis points (bps) or roughly 10% to LIBOR+440 (bps) over the first three months of the year. Currently, spreads are at their second tightest post-crisis level, falling below 450 bps for just the second time since 2007. The bank loan market is now yielding 4.76%, down 0.38% from where it started the year. Yields in the bank loan space remain elevated compared with other traditional fixed-income asset classes, with US Treasury yields at 0.89%, investment-grade credit at 2.67% and agency mortgage-backed securities at 2.52%. Risk outperformed over the period, with CCCs gaining 5.21% versus a return of 1.39% for BBs. Single Bs were up 2.42% for the period. Loans considered large and liquid, as represented by the S&P/LSTA Loan 100 Index, performed basically in line with the broader market at 2.15% in 1Q13. Bank loans outperformed traditional interest rate sensitive asset classes, including US Treasuries (UST) (-0.19% return) and investment-grade credit (-0.17%), as UST yields rose by ~10 bps over the quarter. Riskier asset classes such as high-yield bonds (2.89% return) and the S&P 500 Total Return Index (10.61%) outperformed loans, however. Bank loans were in demand during 1Q13. All told, collateralized-debt obligations (CLOs) and retail investors put a record $40 billion to work over the period. New CLO deals accounted for $26.2 billion in demand, a post-crisis high and the third highest quarter ever. Retail demand for bank loans was also powerful. Over $14 billion flowed into retail mutual funds and exchange-traded funds in 1Q13, the second highest quarterly total. This compares with $8.7 billion in all of 2012, and a record total of $16 billion in 2011. If both CLO and retail demand continue at their current pace, new demand for loans could net greater than $150 billion for 2013. Accompanying the onslaught of demand was record new issuance. Primary volume in the institutional market was $150.2 billion in 1Q13, greater than any previous quarter. For comparison, volume was a post-crisis high of $295.7 billion for the full year 2013. Issuers took advantage of the demand to re-price their outstanding loans at a blistering pace as 63% of new issues were used to refinance outstanding debt. Since bank loans typically have no call protection, companies can pay down their outstanding debt at any time and re-issue loans under more beneficial terms. Because of this dynamic, issuers were able to re-price 23% of outstanding loans in the market downward by an average 108 bps over the period. The all-in yield (including the spread, original issue discount and LIBOR floor benefit) fell to 3.44% for a newly-issued BB rated loan, down 35 bps from the end of 2012. Single B all-in yields declined as well, dropping 66 bps to 5.01%. From a fundamental standpoint, issuer metrics continue to be supportive. Despite a slowdown in the rate of increase, revenues were still up 10% year-over-year for the period ending December 31, 2012. EBITDA margins experienced a similar trend, growing 6.8% in 2012, roughly 2% slower than the 2011 pace. Looking forward, Capital IQ is forecasting an average earnings growth rate of 7.4% for S&P 500 companies in 2013. Cash flows remain strong, however, with coverage ratios well above the long-term average. These factors, combined with low maturities through 2014, should help defaults to remain low. Moody's reported a drop of 0.3% in the issuer-weighted default rate on a quarter-over-quarter basis. The default rate at the end of 1Q13, according to Moody's, was 2.8%. S&P recorded an increase in its trailing 12-month issuer-weighted default rate, up 0.4% during the quarter to 1.8%. The jump was more pronounced when looking at the dollar-weighted default rate, which increased to 2.2% from 1.3% at the end of 2012. The increase in the dollar-weighted default rate was due primarily to $4 billion in loans linked to oft troubled directories publishers Supermedia and Dex-One. Both companies filed for Chapter 11 and have pre-packaged reorganization and merger plans.
How to Invest
Western Asset Focus Materials
Read our Bank Loan Brochure which covers the history and potential benefits of this asset class
The following whitepapers are relevant to the use of Bank Loans within a portfolio.
As investors, we know that income is an essential component of total return. Income clearly demonstrates its importance in the fixed-income market, but is also critically important in equities, real estate and currency investing. One of the key issues that investors must confront today is the prospect of receiving significantly less income in the future than they have in the past, primarily due to the efforts of the US Federal Reserve (Fed) to lower most interest rates.
Most of us have learned the rule of 72 somewhere along the way in our financial careers. Simply stated, divide 72 by your expected annual return and the result will be the approximate time it will take for your investment to double. Historically, the 10% annualized return expectation for equities suggested that an investment would double in just over seven years (72/10).