The clamor around the timing of the first increase in US interest rates in more than seven years is reaching a crescendo, as the all-important September meeting of the Federal Open Market Committee (FOMC) draws closer. This may be causing investors to rethink their investment strategies. Mark Boyadjian and Reema Agarwal of Franklin Templeton Fixed Income Group take a look at the implications of a changing-rate environment for investors in bank loans, also called leveraged loans.
For certain investors—in particular pension funds and insurance companies that tend to follow a more cautious investment strategy—the extended period of record or near-record low US interest rates has been a thorn in the side. Many such institutions rely on investment returns to meet commitments or drive profitability and have been beleaguered by the low yields inherent in the current environment.
As a result of a search for yield among such constituents, some of these institutions have been looking at asset classes outside conservative low-yielding government and corporate bonds. One of these has been leveraged loans or bank loans, which offer the potential to provide a fairly attractive level of income with minimal interest-rate risk, because the coupon adjusts. For example, at the end of 2014, the Credit Suisse Leveraged Loan Index had an average coupon greater than 4.75%, duration1positioning of less than 0.25 years, and an average dollar price below par.2
FLOATING RATE DEBT MARKET
The floating-rate debt market consists of below-investment-grade credit quality loans that are arranged by banks and other financial institutions to help companies to, among other things, finance acquisitions, recapitalizations or other highly leveraged transactions. Although leveraged loans are considered below investment grade in credit quality, typically their “senior” and “secured” status can provide investors and lenders a degree of potential credit risk protection.
Floating-rate debt goes by many names which can be used interchangeably, including: leveraged loans, bank loans, syndicated leveraged loans and floating-rate bank loans.
We believe concern regarding anticipated increases in US interest rates is going to continue to have implications for fixed-rate and floating-rate assets. In that context, our view is that fixed-rate assets—particularly those with a duration of five years or shorter—may be experiencing material principal declines as a result of the interest-rate risk they possess.
While our outlook for the corporate credit market generally is positive for the balance of this year, we’re growing increasingly concerned about the potential credit risks that could develop in 2016 and 2017. Our concerns stem from the sense that floating-rate debt, like many asset classes, is sensitive to the laws of demand and supply.
In the context of rising rates, we believe many investors will seek to shed their duration and flock to assets that they perceive as having yield without duration, which may include leveraged loans.
Bank loans may offer a few key characteristics that may look attractive to many investors within the context of a rising rate environment.
- The duration on a leveraged loan is typically very low. If interest rates rise, price sensitivity is generally much less relative to a high-yield bond alternative.
- Leveraged loans are considered below-investment-grade in credit quality, but their “senior” and “secured” status can provide investors/lenders a degree of potential credit risk protection.
- Historically, leveraged loans have had a relatively low or even negative correlation3 to traditional fixed income vehicles such as government bonds.
- The floating-rate feature in leveraged loans means that as short-term interest rates go up, the corresponding income on loans typically should go up as well.
Supply and Demand
Interest rate dynamics can have important implications in terms of supply and demand for the asset class. Traditionally, leveraged loans have derived the majority of total return from income. The majority of that income is derived from the underlying benchmark; LIBOR (the London Interbank Offered Rate) is the benchmark for US dollar-denominated term loans. Euro-denominated loans use EURIBOR, a similar measure to LIBOR. LIBOR represents the average interest rate estimated by leading banks in London that the average leading bank would be charged if borrowing from other banks, and it tends to track movements in the US Federal Funds rate. As a result, LIBOR would be expected to rise as US interest rates rise. In a rising LIBOR environment, we expect the demand for leveraged loans as an asset class could likely exceed the supply.
When you put that in the context of three other crucial issues—rising leverage levels, increasing covenant-lite issuance4 and record collateralized loan obligations formation—what we see occurring is a ballooning of the level of credit risk as a result of the increase in demand. A covenant-lite loan is a type of loan whereby financing is given with limited restrictions on the debt-service capabilities of the borrower.
Rising Leverage Levels
In general, at this time, coverage levels—the notional ability to service debt— appear to be very comfortable.
Current leverage levels are approaching the historical peaks seen in 2007, but with historically lower interest rates, according to our analysis, companies in general appear well able to cover their interest costs at this time. In this context, leverage refers to the amount of debt used to finance a firm’s assets.
It’s also our view that adjustments to earnings before interest, taxes, depreciation and amortization (EBITDA) are likely to increase over time, so it is likely this leverage may be understated versus companies that are coming to the loan market at this point.
Leverage can increase for one of two reasons:
- The borrower can maintain their earnings but increase the amount of debt outstanding.
- The amount of debt can remain constant but the earnings can decline.
When it comes to the demand/supply situation, our concern is that there will be an increase in the total amount of debt outstanding—either senior or total—and in our opinion, that could cause a situation where credit quality may deteriorate and investors may in turn receive less compensation for it.
This is where credit quality comes in. Companies that are at the higher end of the company credit-quality spectrum should have a better ability to handle the eventual rise in interest rates. Conversely, we think that companies in the middle and lower tiers of credit quality are likely to suffer more of the pain when interest rates rise.
Continuously Callable
Although leveraged loans are very much like high-yield credit, they are different in important ways: They are floating rate versus fixed, and they are continuously callable. That means borrowers have the option to refinance their loans.
This influences the supply/demand concept and the deterioration of credit quality, because as demand exceeds supply and loans begin to trade above par, many borrowers will exercise their option and refinance their loans at a lower spread. This has two primary effects for investors: It caps principal appreciation potential, and it reduces the income they are receiving for the same level of credit risk.
When one sees higher demand levels, one would expect to see higher issuance levels. Our view is that issuance would be more rated toward the middle credit quality and the lower credit quality subspace of the loan market. As a result, we think the market composition would likely change to increase middle tier and lower tier.
Covenant-Lite
Generally as issuance and demand increases, companies would typically try to remove covenants or try to come to market without covenants.
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