In this Q&A, Portfolio Manager Timothy J. Settel provides an overview of managing US bank loan assets, market inefficiencies and current portfolio positioning.
TJ: Our fundamental belief is that inefficiencies exist in the bank loan asset class, which result from the misinterpretation of fundamental credit metrics and/or supply and demand imbalances. Western Asset’s bank loan product utilizes the expertise of a veteran group of portfolio managers, credit analysts and traders who have a long history of successfully seeking out those inefficiencies using issue selection, industry positioning and rating allocation as the primary strategies in an effort to generate outperformance.
TJ: We have a positive view regarding the existing attractiveness of the bank loan asset class relative to other fixed-income investment options. Loans offer a high level of current income and the product’s floating rate component offers the opportunity to earn a higher level of income if rates move higher.
TJ: If and when rates start to rise in a meaningful way, we believe bank loans should perform very well. However, that isn’t something we expect to happen anytime soon. Our view on rates is that the Fed will begin to raise rates later and more gradually than the market is expecting so our positive outlook on loans is not predicated on rising rates. When rates do start to move higher, coupons on bank loans will start to rise as well. There will be a bit of a lag, though, as a majority of loans have a floor feature, which limit how low the loan coupon can go. Most loan floors are “in the money,” meaning that the LIBOR rate would have to rise between 50 and 75 basis points before investors would receive additional coupon income over what they currently earn.
TJ: From a sector perspective, we are fairly defensively positioned. We are underweight the historically high volatility sectors, including technology and consumer cyclicals, and overweight the historically low volatility sectors including consumer non-cyclicals and energy. From an issuer perspective, we are more aggressive. We have an overweight to lower rated categories, including second lien loans and high-yield bonds, and an underweight to higher rated issues.
TJ: The overweight to energy has resulted in underperformance. The S&P/LSTA Performing Loan Index ex-energy has generated about a 2.25% return so far this year while the energy loan sector is flat. Historically, energy has been the least volatile sector with the lowest default rate. Its assets are fungible and divestible in periods of stress, and during challenging environments energy companies have quickly instilled capital discipline. Energy assets do not suffer from obsolescence or go out of fashion. However, with the dramatic decline in oil prices since 4Q14, energy loans have been the bottom performing sector. In addition, our energy exposure has generally been in more leveraged companies, which has also challenged performance.
TJ: Outside of the energy, retail and metals and mining industries, balance sheets and income statements are in decent shape, in our opinion. Cash flows are generally good, issuers have ample access to capital, and in some cases, we’ve seen a decline in leverage. In general, leverage is lower for the average loan issuer than the long-term historical average and liquidity levels are near the all-time high. Loan issuers have less than $25 billion in bank loans maturing within the next 2 years, all of which add up to an expectation of default rates remaining low for the foreseeable future.
TJ: The supply and demand balance for bank loans is much improved when compared with 2014. Though we continue to see outflows from mutual funds, they have moderated, totaling about $5 billion year-to-date (YTD).1 Collateralized loan obligation (CLO) issuance, and therefore demand for loans, has been strong. YTD, CLO issuance has totaled about $25 billion.1 On the supply side, new issuance has been very modest. Net new issuance of loans is around $30 billion, down 56% year-over-year.1 If we get to the point where mutual fund outflows stop or turn positive, the technical condition of the market will be in very good shape.
TJ: As I mentioned earlier, yes, we believe there are inefficiencies in the loan market. Let me use CLOs as an example. They are a bank loan model-driven product structured to meet certain criteria including average ratings, loan prices and weighted average spreads. The loans are not marked to market. Most CLO managers make investment decisions that are more driven by what makes the structure of a CLO work rather than by relative value considerations. Sometimes this results in the valuation of certain issuers, issues, industries and rating categories getting out of whack, creating market inefficiencies that we seek to use to our advantage.
TJ: In addition to consumer non-cyclicals and energy, we like the utility and transportation industries as well as select plays within metals and mining. The regulated nature of the electric utility industry provides a fairly dependable cash flow stream for these issuers. In transportation, the airline sector has done a good job of rationalizing its business, resulting in higher load factors of approximately 80% and moving higher. Lower energy prices clearly benefit the industry as well. Valuations have moved significantly wider across the metals and mining industries in sympathy with lower commodity prices. The selloff has been fairly indiscriminate resulting in what we see as attractive opportunities in specific higher quality credits.
TJ: In addition to consumer cyclicals and technology, we are underweight financials. Non-investment-grade financials have a much higher cost of capital. In an industry where the lowest cost of capital companies have a huge competitive advantage, we don’t believe non-investment-grade financial issuers can compete for long.
TJ: We believe current valuations price in a level of pessimism that we do not share. When oil prices started to break in September 2014, we were long energy. We actually looked for oil prices to fall from lofty levels set that month but we didn’t anticipate prices falling by more than 50%. The price of energy issuers’ loans dropped quickly and sharply, and at the time, there was little, if any, opportunity to make strategic changes to the energy position. Dealers refused to provide liquidity as they were focused on reducing inventory levels heading toward year-end. As the new year began, prices firmed a bit and a degree of liquidity has returned, allowing us an opportunity to optimize our energy positions given the changed landscape. Our view at this point is that given the significant reduction in future energy production relative to expectations of last fall as well as a very conservative view on increasing demand, oil prices should begin to increase in the near term. We don’t expect to see $100 oil again anytime soon, but for this sector to do well from a debt-owner perspective, we just need to see prices firm up to around $60 per barrel by year-end.
TJ: We are most likely in the later stages of the cycle. Though we don’t expect a meaningful pickup in defaults in the next 2 years, we’re taking steps to reduce risk in the portfolio—the thought being that if we wait to see an increase in defaults, it may be too late. For example, within the energy sector we’ve reduced our oilfield services holdings, which tend to be the volatile part of the energy sector, in favor of select higher quality E&P exposure. Further, we will look to opportunistically reduce our exposure in high-yield bonds.
- Source: LSTA