In this Q&A, Portfolio Manager Timothy J. Settel outlines why we believe bank loans present an attractive investment opportunity.
TJ: The current investment environment is dominated by uncertainties, both domestically and globally. Therefore, it may be prudent for investors to seek higher-yielding/lower-volatility products, and bank loans can be an excellent option for those investors looking for such characteristics. The current bank loan market is yielding LIBOR+425 which looks attractive relative to other fixed-income credit related sectors and allows the added benefit of a floating-rate coupon and being senior in the capital structure. These characteristics are the reason loans exhibit significantly less volatility relative to other spread products.
TJ: On an absolute valuation basis, both high-yield bonds and bank loans look attractive. However, individual investor risk appetite will ultimately determine which asset class is preferred. We find that loans currently offer a better risk-adjusted return relative to high-yield bonds. In addition, we like that loans have a floating coupon and are (historically) significantly less volatile than high-yield bonds, both features that lead us to a bias toward loans.
TJ: We remain long risk relative to the benchmark although the degree to which we are long has come down over the past six months. Our long risk position is most evident in how we’ve positioned our portfolios by rating category. From a ratings perspective, we are overweight the lower tier, B/CCC and underweight the higher BB tier. In addition, we see value in select second lien opportunities. Here, however, we are well aware that these investments have reduced liquidity and therefore we have limited the portfolio’s exposure. We believe issue selection will be a key driver of returns this year and, as such, the strategy has many research-driven credits that we believe should add alpha in the near future. For diversification, along with specific relative value reasons, we have maintained a position in high-yield bonds, though at a reduced level from six months ago.
TJ: We believe that the overall credit fundamentals are solid. Leverage has crept up over the past 12 months, but ex-energy, leverage has remained fairly stable. Interest coverage ratios remain near record highs and companies have continued to generate free cash flow. Loan maturities have been pushed out and very little debt becomes due in the next 24 months (see Exhibit 1). While the overall market is solid, there continues to be stress in the energy servicing sector and in retail. The retail space, in particular is an area where we expect to see continued weakness.
TJ: The technical picture for the loan market looks very strong. We have seen almost 30 weeks of consecutive inflows into retail-related funds, and given our view that rates will go higher, we expect that retail investor demand for loans will remain elevated. Collateralized loan obligation, or CLO, issuance has been slow since the beginning of the year, but we expect this activity to pick up as well once spreads normalize. In bank loans, new issuance has been elevated, but over 60% of the deals have been for refinancing purposes. Net of refinancing, demand has been outstripping supply.
TJ: Given the light maturity schedule and a supportive fundamental backdrop, we expect the default rate to remain muted. We expect loan defaults to stay below historical average levels for the next 12-18 months.
TJ: The past 10 years have been mostly about top-down positioning, but with the macro environment so uncertain, we think this year will be more about old-fashioned name selection. Therefore, we will be relying on our research-intensive credit work to drive alpha, a key differentiator for Western Asset.
TJ: In the broadest sense, we think tax reform will be very good for corporate borrowers. But there are many details that have yet to be determined and we look forward to getting more details of what will ultimately be proposed and implemented.
TJ: We think the economy continues to be on solid footing, yet we believe growth will remain unspectacular. Our GDP range continues to be in the 1.5%-2% area. We see little inflationary pressure and we think that global central banks will remain accommodative for the foreseeable future. The biggest risk to the economy at this point seems to be focused on a policy misstep by the new administration, but we are also keenly interested in the European elections and domestic interest-rate policy.
TJ: We think the economy remains on solid footing, but we are not looking for the economy to break out of its 1.5% to 2% GDP growth range. With that economic backdrop, we are in the camp of one or two Fed hikes in 2017.
TJ: We recognize that the current cycle has outlived the typical credit cycle, but we still believe that the current cycle has at least two to three years left. This cycle is different in the fact that global central bank policy has been so accommodative that investors are still incentivized to invest in a higher-yielding asset class. In addition, from a fundamental point of view, we think issuers have done a very good job of maintaining and enhancing their balance sheets, helping extend the life of this cycle.