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Over the past decade, yields on many developed market bonds have declined materially. In some markets, bond yields have even turned negative with investors effectively paying for the privilege of holding bonds. It is therefore not surprising that many investors have looked for alternative sources of income that also provide protection from rising inflation and interest rates.
Corporate loans are floating-rate, senior secured debt issued by companies. They are rated below investment grade. Some countries refer to them as ‘bank loans’ or ‘senior secured loans’. They offer borrowers relatively easy access to funding compared with issuing a bond. And while the loan repayments can be more expensive compared to a corporate bond, there is more flexibility. This includes the ability to pre-pay some or all of the debt.
These attractions have led to strong growth in the number of outstanding loans.
This loan market growth has come from a number of sources. Collateralised loan obligations (CLOs), vehicles which hold portfolios of loans and issue a range of securities against them, are the largest buyers of loans. The CLO market as a whole has grown substantially post-global financial crisis and has been a significant buyer of newly issued loans. In addition, the continued hunt for yield has led to increasing investment from both institutional and retail investors through products such as mutual funds and exchange-traded funds (ETFs).
This strong demand for loans has had a profound effect on the market.
This strong demand for loans has had a profound effect on the market. To take on the higher risk of holding loans (compared with holding cash) investors require a higher return. This return is expressed by the credit spread above LIBOR (the London Interbank Offered Rate). But spreads for both newly issued debt and existing loans have declined over time. Even with greater loan market volatility towards the end of 2018, the credit spread of the S&P LSTA Leverage Loan Index was just 3.5% as at 8 March 2019. This index represents the largest, most liquid loans.
Additionally, persistent demand for floating rate loans has also allowed borrowers to exert more control over deals and offer less attractive terms through weaker covenants. This has led to growth in “cov-lite” loans which have less stringent financial tests for borrowers. This could allow companies to take riskier investment decisions and will likely lead to lower recoveries on defaulted loans.
Investors often access the asset class via specialist loans funds. However, prospective returns have declined and perceived risks to the asset class as a whole have increased. As such, ASI’s Diversified Assets team’s current preference is to gain exposure to loans via funds investing in asset backed securities (ABS). These funds, which invest in a range of credit-related securities via different risk-targeted tranches, generally include exposure to corporate loans via CLO investments. They often hold a broad range of medium-risk securities, with exposure to other asset classes such as residential and commercial mortgages. Currently, we think such funds offer increased diversification benefits and a better risk/return combination than a portfolio of corporate loans.
The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.
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