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Bank loans: Resiliency amid volatility

Multiple authors
2022-08-01
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Fed embarks on much-anticipated rate-hiking campaign

Emboldened by a strong US economy and mounting inflationary pressures, the US Federal Reserve (Fed) enacted its first 25 basis-point (bp) increase in interest rates since 2018. Additionally, Fed Chair Jerome Powell’s recent rhetoric has become more hawkish, including suggesting the possibility of a 50 bp rate hike in the coming months. The market is now pricing in the fed funds rate to rise to around 2.5% by the end of 2022 (from its current target of 25-50 bps).

Historically, rising-rate environments have been challenging for most fixed income assets, as bond yields and prices tend to be inversely related. (When yields go up, prices typically go down and vice versa.) However, as floating-rate instruments whose coupons reset higher as interest rates rise, bank loans actually stand to benefit from rising-rate regimes. With the market now bracing for more aggressive Fed tightening over the next 12-18 months, bank loans look poised to provide investors with higher levels of income going forward, while also potentially limiting the negative price impact from rising rates.

Floating-rate coupons, senior secured credit: Key loan features

Volatility has flared up across financial markets to start 2022 — geopolitical risks in Ukraine and elsewhere, persistent inflationary pressures, more hawkish global monetary policies, and ongoing COVID-related concerns have been among the main culprits.

Amid increased recession risks in some parts of the world (particularly Europe), and the specter of rising rates to combat higher inflation, bank loans have proven quite resilient relative to other credit sectors. Figure 1 highlights the year-to-date cumulative performance across multiple asset classes. As shown, bank loans weathered much of the impact from both rising rates and spread widening that plagued many sectors, outperforming US high-yield bonds and investment-grade debt by over 450 bps and 575 bps, respectively.

Given the floating-rate nature of their coupons, paired with their senior secured position atop corporate capital structures (i.e., being secured via lien against the borrower’s assets), we believe bank loans may continue to hold up well in the period ahead — and that many investors should (and will) favor the sector over other credit assets in today’s uncertain, potentially volatile environment.

Figure 1
bank-loans-resiliency-amid-volatility-fig1

Our 2022 forecast: “In-line” US growth, low default rates

Given the Russia/Ukraine crisis, along with other geopolitical risks and the threat of rising inflation, there are clearly macroeconomic headwinds blowing through the global landscape. However, we still believe the US economy is well-positioned to withstand potential supply-side inflation coming from Russian export curtailments, buoyed by strong US corporate and consumer balance sheets and less reliance than Europe on energy imports. We forecast the US economy to growth at a 2% – 3% clip in 2022, slower than last year, but still in line with its long-term trend growth rate.

From a fundamental perspective, the majority of bank loan issuers entered 2022 on solid footing and remain so. (However, we believe lower-quality issuers with tighter profit margins may be negatively impacted by higher input costs, especially in commodity-sensitive sectors.) Despite the greater risk of European recession, elevated commodity prices, and their overall upward impact on inflation, we still anticipate a fairly benign credit default experience for the bank loan sector. It’s also worth noting that because of their senior secured position in corporate capital structures, loans have historically provided higher recovery rates in the event of default than unsecured high-yield bonds.

Bottom line: Still bullish on floating-rate bank loans

In the wake of recent global market volatility, we believe current bank loan valuations may offer investors more compelling entry points than even just a few months ago:

  • The S&P/LSTA Leveraged Loan Index (a broad proxy for the bank loan market) is now priced at 97.6, providing both modest capital appreciation potential and attractive levels of investment income.
  • As discussed above, the likelihood of a rising-rate scenario in 2022 and beyond also supports the attractive income opportunity available from bank loans. If in fact the Fed delivers on its (and the market’s) rate-hike projections, we expect loans to benefit more than longer-duration bond sectors.
  • Not only have retail investor flows into loans been positive so far in 2022, but we expect a favorable technical backdrop, given strong demand for collateralized loan obligations (CLOs).
  • Lastly, we believe greater issuer dispersions in the bank loan market may present opportunities for skilled credit selection to potentially drive enhanced returns.

Experts

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