The Disillusion of Floating Rate Loans
Peritus Asset Management, the portfolio management team of the AdvisorShares Peritus High Yield ETF (HYLD), highlights the value of active management and the advantages that high yield bonds have in a rising rate environment.
There has been a remarkable interest in bank loans over the past few years. We have seen $50.6 billion flow into bank loan exchange traded and mutual funds just this year. November was the fourth largest month of institutional loan issuance on record, with $70.4 billion issued in the month and $621.8 billion YTD. This handily beats the prior record high of $388 billion, seen in 2007.1 And the statistic that gets me the most: we’ve seen 77 consecutive weeks of inflows into bank loan mutual funds and ETFs. Because these are floating rate securities, there has been a massive interest in this space by those concerned about higher rates.
At face value this seems like a “no brainer” trade, and many have embraced it as such, but the actual numbers tell a bit of a different story. YTD, floating rate loans have returned 4.8% versus 7.6% for high yield bonds.2 This has been in a year when the 10-year Treasury yield has gone from 1.78% at the end of 2012 to 2.88% today. It would seem that if floating rate loans are really the answer to rising rates, we would have seen a better return, especially given the massive inflows into the asset class. And even with the 10-year yield increasing by over 1.1% (or over 50% from the beginning of year yield), the high yield market has still well outperformed the loan market this year, helped by the higher yields available in the bond market.
The first thing to come to mind is that even with all of the money flowing into the loan asset class and chasing securities, there are many overvalued names in the space. Also, the general perception seems to be that loans are always less risky than bonds. However the reality is that many companies have capital structures that consist entirely of loans and some of those loans are still part of capital structures that are very highly levered. Additionally most loans have LIBOR floors, meaning we would need to see a substantial rise in short-term LIBOR rates before there was any impact on the coupon paid on the loan. Instead of seeing a broad loan allocation as the panacea to rising rates, we view the market as a selective opportunity for active managers. By investing a portion in the loan asset class, the investment universe can be expanded as there are certain loans within the space that remain undervalued and offer attractive yields; these selective opportunities must be weeded out from the rest of the overvalued names.
We continue to believe an actively managed portfolio consisting largely of high yield bonds is still the best way to be positioned in this environment. Additionally, it remains very unclear to us whether much of the rate rise expected by market participants has already been priced in. While tapering means the Federal Reserve will be backing off of purchasing both mortgages and Treasuries, there remains substantial demand from fixed income investors, particularly pension plans focused on LDI, or liability driven investing. But if rates do rise further, higher starting yields help cushion the portfolio from interest rate movements, and historically, this year included, high yield bonds have actually performed well during periods of rising rates (see the historical data in our piece “High Yield in a Rising Rate Environment”). We believe that those who expect a broad allocation to bank loans to be the answer to generate returns in this environment may well be disappointed.
1Acciavatti Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update.” J.P. Morgan High Yield and Leveraged Loan Research, North American Credit Research. December 6, 2013, p. 1.
2Acciavatti Peter, Tony Linares, Nelson Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “Credit Strategy Weekly Update.” J.P. Morgan High Yield and Leveraged Loan Research, North American Credit Research. December 6, 2013, p. 25.