2018 has meant an interesting start to the year. We have seen several interest rate hikes in the US, which has affected the bond market. This has also led to the first market correction, which has caused volatility to diminish from the slumber it has rested in since 2017. This frenetic type of startup can lead to investors analyzing their current asset allocation. One market sector that continues to attract interest is loans. This applies in particular to secured loans, so-called senior loans where the repayment – in addition to relevant collateral – must also be secured by stable cash flows. Issuing bonds is a way for companies to borrow money without having to go to the bank.
We have previously discussed the possibility of covered bonds, sometimes referred to as covered loans. They can help shorten the duration while generating income in the credit portfolio of a portfolio. However, today’s environment, which is marked by higher interest rates and volatility, has further strengthened the case for loans, which means that four of the highest loans’ best attributes are: their seniority in the capital structure. their ability to produce low-duration income, their changing interest rate structure; and their ability to provide portfolio diversification. Below are four charts that illustrate how these attributes can be a valuable complement to a core interest portfolio in today’s market.
Secured loans have seniority
Investors have worked for a long period of record low interest rates, many turned to high yield bonds for double-digit returns. But the story can no longer be on the investors’ side when they expect such a high return.
Since the beginning of 2016, high-yield spreaders have sharpened and are now 39% below their historical average. At the same time as we enter the later stages of the credit cycle, the chart below shows that high-yield downgrades have outperformed upgrades over the past three years, and the trend has continued into 2018. If issuers continue to downgrade and bond prices fall , the risk / reward trade-off required to get high returns is no longer as compelling as it once was.
Senior loans are variable interest-bearing debt issued by companies that come with a collateral requirement. While their credit quality is often below investment grade, just like high yield or high yield bonds, the senior loans are higher than high yield in the event of the issuer’s bankruptcy. This means that senior loans have a higher recovery rate than traditional high yield bonds, which makes them potentially less risky than high yield bonds issued by the same company. This is illustrated by loans that outperform high returns with fixed interest rates by 57 bps in months when credit spreads have increased based on the return date from 1994 to 2017.
Senior loans provide higher returns and have lower maturities
As shown in the table below, the majority of interest-bearing assets generate a return less than the historical average offered by the Goodberg Barclay’s US Aggregate Bond Index (“AGG”), a traditional core bond exposure. This means that many investors have sought out riskier segments, such as high-yielding bonds, to gain access to returns.
Just like high-yielding bonds, senior loans have the potential to generate increased income levels, as they are considered speculative loans. The chart below shows that secured loans can generate the increased level of income while providing a much lower maturity than high yield bonds. By putting this in duration and sitting higher up in the capital structure, senior loans will be able to navigate better in the credit cycle in the late cycle. This is when we see rising interest rates, increased leverage, more downward adjustments. This makes secured loans better suited to a traditional high yield allocation. These benefits may be more pronounced in the current rising interest rate environment.
In January’s Federal Open Market Committee (FOMC) meeting notes, FED officials stated their intention to raise interest rates three times this year. The likelihood that the Fed’s interest rates will rise at the next meeting is currently at 100 percent and speculation has emerged that four hikes – rather than three – could be justified in 2018.
While concerns about inflation and rising interest rates were triggered in February stock market sales, the chart below shows how senior loans managed sales far better than their counterparts. Rising interest cycles support senior loans as these loans offer an interest rate coupon that is adjusted every three months. Add this to their seniority in the capital structure and the cutbacks in the recent sell-off were not as serious.
Senior loans offer a diversified interest portfolio
One of the principles of a core interest portfolio is its ability to provide revenue, stability and diversification. This core portfolio can be complemented by exposures that offer increased diversification. While senior borrowers have the ability to provide income and stability, they can also provide diversity, given their low-to-negative correlations with traditional bond sectors.
The diagram below captures the low correlations of the senior loan and the high yield loan with many traditional bond sectors. Senior loans show lower correlations with these asset classes than high-yield bonds, which improves the diversification of an interest rate portfolio.
Use an exchange-traded fund to get exposure to senior loans
When interest rates move in favor of senior loans, investors may want to consider accessing this type of bond using the SPDR Blackstone / GSO Senior Loan ETF (SRLN). There are also other exchange traded funds that offer this exposure. Investors who are unsure whether an ETF is right for them should know that SRLN is an actively managed senior loan fund. SRLN’s active management makes it possible to focus on credit choices in order to avoid a weak or inadequate loan that can be part of a passive strategy.
GoHeartMedia Inc. is a very new but good example; After a year hovering on the bankruptcy threshold, the company has filed for bankruptcy. An index fund would probably hold a position close to its reference weight, regardless of credit quality or liquidity cost per exposure.
In addition, an ETF’s primary and secondary market trading may increase liquidity. Many fixed income funds, including SRLN, have developed robust secondary markets (trading ETF shares on exchanges), where buyers and sellers interact freely. This secondary market offers a price transparency and the ability to liquidate positions without using the primary market.