Why does the bank loan sector remain so attractive?
OSSINO:
At Newfleet Asset Management, our view is that the near-term outlook for the bank loan sector is particularly favorable, especially compared to other fixed income sectors. With interest rates near zero, the next move will likely be a rate increase. When that happens, floating rate bank loans will pay higher interest rates, and loan owners will collect a higher yield. In addition, the economy is continuing to heal, with default rates low and expected to remain low (our 2015 forecast is 1.5-2.0%). This moderate growth, benign credit environment bodes well for credit-intensive spread products, including loans. Between today’s improving macro environment and the inherent characteristics of bank loans, investors have the opportunity to nearly eliminate interest rate risk and partially mitigate credit risk without giving up much yield, relative to other fixed income alternatives.What are floating rate bank loans?
OSSINO:
Floating rate bank loans (“bank loans”), also called leveraged loans, are loans made by large commercial banks to corporate customers, most of which are rated below-investment grade. Investment grade companies rarely borrow from banks and instead raise financing by issuing long-term debt or short-term commercial paper, options generally not available to lower-rated firms.Bank loans are issued to a wide variety of companies in a broad array of industries, from consumer products, to technology, to health care. While the final maturity specified in a loan agreement may be six to eight years, the effective maturity or average life of a bank loan is typically three years, because the borrower can repay or refinance at any time, usually without penalty. Bank loans are typically rated BBB- to C in credit quality, with the bulk of the loan market in the BB to B range.
Bank loans are so named for the “floating” rate they offer, which is indexed to a short-maturity base rate, such as the three-month LIBOR (London Interbank Offered Rate). As LIBOR moves up or down, the interest rate the borrower pays also fluctuates, significantly reducing risk tied to interest rate moves.
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Bank loans present a compelling income opportunity and a portfolio diversifier that
provides protection against traditional fixed interest rate risk, along with structural
advantages typically not available in income asset classes which may help to protect
against credit risk. Frank Ossino, senior managing director and head of the bank loan
sector at Newfleet Asset Management offers his views on this growing $950 billion
fixed income market.
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How are bank loans earning their yield?
OSSINO:
There are three components to a bank loan’s yield:• the loan price;
• the LIBOR base rate; plus
• a credit spread over LIBOR.
Currently, bank loans are priced near par (face value), so future returns are not likely to come from price appreciation, but rather from the coupon (payable interest). While spreads appear to be tightening, they still remain attractive and are actually higher in the current low default environment (0.61%, as of 3/31/15, excluding Energy Future Holdings) than during the recession of the early 2000s when the default rate was about 8%.
The recent advent of the LIBOR “floor” has resulted in incremental yield for many bank loans. This feature guarantees investors will be paid a certain level of interest by setting a floor (not a cap) on the loan’s base rate.
In effect, the loan market is receiving incremental yield as if the LIBOR was higher than it actually is today. About 89% of the loan market1 has a LIBOR floor, and 73% of the loans we invest in for our portfolios have LIBOR floors. In a market that is still priced near par, the LIBOR floor dynamic, plus attractive spreads, provides a compelling yield opportunity, especially relative to other alternatives.
What are ways bank loans may help address risk in a fixed income portfolio?
OSSINO:
1. Lower interest rate risk, increased income potential – A fixed income security’s interest rate sensitivity is measured by its duration, expressed as a number of years. The longer a security’s duration, the greater the impact a rate change (in either direction) will have on its price. Bank loans are effectively “duration-neutral,” meaning that as interest rates rise, the total coupon of the loan increases, thus preventing the loan from losing value from interest rate increases. Fixed-rate securities, however, lose value when interest rates rise, the magnitude of which depends on the duration.Interest Rate Loans versus Fixed Income Sectors (as of 3/31/15)
Yield is represented by yield to worst. Yield to worst is the lowest potential yield calculated by taking into account an issue’s optionality such as prepayments or calls. Bank loans are represented by the S&P/
LSTA Bank Loan Index using yield to maturity as yield to worst is not calculated for this index. Corporate High Yield represented by the Barclays U.S. Corporate High Yield Index. Corporate Investment Grade is represented by the Barclays U.S. Corporate Investment Grade Index. U.S. Aggregate is represented by the Barclays U.S. Aggregate Bond Index. U.S. Treasuries are represented by the Barclays U.S. Treasury Index. Municipal Bonds are represented by the Barclays Municipal Bond Index. Indexes are unmanaged and not available for direct investment.
Source: Barclays Live and S&P/LSTA. See page 5 for index descriptions.
Past performance is no guarantee of future results.
Yield (%)
Modified Adjusted Duration (years) High-Yield Loans Corporate High Yield
Corporate Investment Grade Municipal
Bonds U.S. Aggregate
U.S. Treasuries
0 2 4 6 8 10
0 2 4 6
8 Yield to Worst
1As measured by the Credit Suisse Leveraged Loan Index as of 3/31/15.
LIBOR FLOOR EXAMPLE:
If a loan has a LIBOR floor of 1.00% and the 3-month LIBOR falls below this level, the base rate automatically resets to 1.00%.
The company issuing the loan (the borrower) will pay the floor (1.00% in this example) plus the credit spread until LIBOR rises above the floor, at which time the borrower will then pay the true LIBOR rate plus the credit spread.
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Because current interest rates are so low, duration should be a critical consideration for fixed income investors. Even a small rate increase would have a negative impact on the returns of fixed-rate securities with longer durations. For example, as shown in the chart, a 1% increase to interest rates would cause a portfolio of investment grade corporate bonds currently yielding 2.91% to lose 7.41%, or the equivalent of 2.55 years in returns. By comparison, the yield on a portfolio of floating rate bank loans would not be impacted by the same rate change;
in fact, the coupon would increase.
2. Credit risk eased by senior status – Bank loans are senior obligations in the issuer’s capital structure, relative to unsecured debt, subordinated unsecured debt, and stock.
Therefore, in the case of a default, bank loans have the first claim on company assets for repayment of the loan before any other debt or equity holders are repaid. The “recovery rate” is the percentage of loan principal that a lender receives in return in the event of a default.
While bank loans are intended to be repaid with the issuer’s cash flows, they are also typically secured by a claim against the issuer’s assets as collateral, including receivables, inventory, property, trademarks/patents, and stock in subsidiaries. This potentially provides a secondary source of repayment if the issuer is not able to meet its payments with cash flow alone.
Between 1987-2011, the recovery rate2 (of principal) for bank loans averaged about 80%, compared to 48% for unsecured bonds. This means that a bank loan lender would have received, on average, $0.80 of principal in return for each $1.00 lent, as compared with $0.48 for the holder of a senior unsecured bond. In fact, looking at three default cycles3, bank loans significantly outpaced other loan categories in each.
In addition to their senior, secured status within the capital structure, bank loans usually come with covenants, provisions of the loan agreement that restrict the borrower’s behavior in order to protect the lender’s interests during periods of financial stress. Covenants can specify things such as the maximum level of debt the issuer may take on. If covenants are violated, the borrower and lender negotiate new, tighter terms, usually for a fee and higher coupon to be paid to the lender.
Source: Barclays Live, as of 3/31/15. Corporate High Yield represented by the Barclays U.S. Corporate High Yield Index. Corporate Investment Grade represented by the Barclays U.S. Corporate Investment Grade Index. U.S. Aggregate represented by the Barclays U.S. Aggregate Bond Index. U.S. Treasury represented by the Barclays U.S. Treasury Index. See page 5 for index descriptions. Past performance is no guarantee of future results.
Index
Current
Yield* Duration
Price Impact of
1% Rate Increase
Impact on Return
in Years
Corporate High Yield 6.18% 4.21 -4.21% 0.68
Corporate Investment Grade 2.91% 7.41 -7.41% 2.55
U.S. Aggregate 2.06% 5.45 -5.45% 2.65
U.S. Treasury 1.25% 5.73 -5.73% 4.58
Equity HIGHEST PRIORITY
LOWEST PRIORITY Senior-Secured Bank Loans
Junior Secured Loans
High Yield/Structurally Subordinated Bonds
Senior Unsecured Loans/Bonds
Typical Capital Structure for Corporate Borrowers
2As measured by ultimate recovery, which is the recovery value that creditors actually receive at the resolution to default, usually at the time of emergence from Chapter 11 bankruptcy proceedings. 3A default cycle is defined as the period beginning when the U.S.
speculative-grade default rate crosses above the historical average for the period 1988-2011 and ending when it drops back below the historical average.
Moody’s Ultimate Recovery Database
12/31/89- 12/31/92
9/30/99- 2/29/04
1/31/09- 8/31/10
Bank Debt 80.4% 87.7% 75.8% 78.5%
Senior Unsecured Bonds 48.4% 56.8% 34.0% 44.5%
Subordinated Debt* 28.8% 32.6% 23.1% 25.6%
All Family Recoveries 54.5% 53.9% 48.1% 58.3%
Average Recoveries in Three Default Cycles
Source: Moody’s Investors Service
* Includes senior subordinated, subordinated, and junior subordinated bonds Past performance is no guarantee of future results.
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How do bank loans behave compared to other types of fixed income?
OSSINO:
Due to their unique characteristics, bank loans naturally tend to behave differently than traditional fixed income bonds. Said another way, bank loans historically have a low correlation to fixed-rate bonds, making the asset class useful for portfolio diversification.Correlation, ranging from -1 to +1, is the measure of how close (or apart) two investments’ movements are related.
A -1 indicates perfect negative correlation (a move in the complete opposite direction), and +1 perfect positive correlation (a move in the complete same direction). Of particular note is the correlation of loans to U.S. Treasuries.
Loans have negligible interest rate risk but carry credit risk, while Treasuries are the exact opposite; subject to significant interest rate risk with little to no credit risk. As a result, the correlation of loans to Treasuries is negative.
A case can be made for a strategic allocation to bank loans in a fixed income portfolio, the size of which would depend on the investor’s credit risk tolerance. As a risk management exercise, investors comfortable with the credit risks of this asset class may want to consider redeploying some of their assets from high yield securities, longer- duration corporate bonds, or even Treasuries, all of which are currently priced above par and are more sensitive to future movements in interest rates.
What is the best way for investors to gain exposure to bank loans?
OSSINO:
Bank loans are sold to qualified investors through both primary issuance (a formal syndication process) as well as an active secondary trading market. As a private asset class, bank loans are best accessed by individual investors through a professionally managed bank loan mutual fund. Clearly, manager selection is important. Critical factors include relevant loan market specific experience, investment style and philosophy, and market position relative to the total market.Correlations of Floating Rate Bank Loans to Fixed-Rate and Equity Sectors
Source: Morningstar Direct, for period 1/1/97-3/31/15. Bank loans represented by the S&P/LSTA Leveraged Loan Index. Corporate High Yield represented by the Barclays U.S. Corporate High Yield Index. U.S. Treasuries represented by the Barclays U.S. Treasury Index. U.S. Equities represented by S&P 500® Index. Corporate Investment Grade represented by the Barclays U.S. Corporate Investment Grade Index. U.S. Fixed Income represented by the Barclays U.S. Aggregate Bond Index. Municipal Bonds are represented by the Barclays Municipal Bond Index.
See page 5 for index descriptions. Past performance is no guarantee of future results.
-1.00
-0.75 -0.50 -0.25
0.00
0.25 0.50 0.75
1.00 Municipal Bonds
U.S. Fixed Income Inv. Grade Corp. Bonds U.S. Equities U.S. Treasuries
High Yield Bonds 0.77
-0.36
0.43 0.32 -0.04
0.22
-1.00 -0.75 -0.50 -0.25 0.00 0.25 0.50 0.75 1.00
Move in the Neutral Move in the
Opposite Direction Same Direction
The Virtus Senior Floating Rate Fund
• Defensive, diversified investment style – Attempts to limit downside risk through a combination of core credit analysis, with a focus on identifying “best in class” companies across industries, and active portfolio management.
• Yield generation potential – Low-duration floating rate bank loans currently offer yields comparable to high yield fixed-rate bonds, but with minimal interest rate risk and credit protection due to their senior-secured status in a company’s capital structure.
• Extensive bank loan market expertise – Newfleet Asset Management’s co-managers David Albrycht, CFA, chief investment officer; Kyle Jennings, CFA, head of credit research; and Frank Ossino, head of the bank loan sector, average 24 years of bank loan experience – critical for understanding the nuances of this specialized asset class.
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Is it time your fixed income portfolio broke from tradition and added a bank loan fund? Contact your financial advisor or visit Virtus.com to learn about the Virtus Senior Floating Rate Fund (A: PSFRX, C: PFSRX, I: PXFIX).
Investors should carefully consider the investment objectives, risks, charges and expenses of any Virtus Mutual Fund before investing. The prospectus and summary prospectus contain this and other information about the fund. Please contact your financial representative, call 1-800-243-4361, or visit www.virtus.com to obtain a current prospectus and/or summary prospectus. You should read the prospectus and/or summary prospectus carefully before you invest or send money.
IMPORTANT RISK CONSIDERATIONS
Credit & Interest: Debt securities are subject to various risks, the most prominent of which are credit and interest rate risk. The issuer of a debt security may fail to make interest and/or principal payments.
Values of debt securities may rise or fall in response to changes in interest rates, and this risk may be enhanced with longer-term maturities. Bank Loans: Loans may be unsecured or not fully collateralized, may be subject to restrictions on resale and/or trade infrequently on the secondary market. Loans can carry significant credit and call risk, can be difficult to value and have longer settlement times than other investments, which can make loans relatively illiquid at times. High Yield-High Risk Fixed Income Securities: There is a greater level of credit risk and price volatility involved with high yield securities than investment grade securities. Leverage: When a fund leverages its portfolio, the value of its shares may be more volatile and all other risks may be compounded. Liquidity: Certain securities may be difficult to sell at a time and price beneficial to the fund. Prospectus: For additional information on risks, please see the fund’s prospectus.
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Not insured by FDIC/NCUSIF or any federal government agency. No bank guarantee. Not a deposit. May lose value.
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6557 5-15 © 2015 Virtus Investment Partners, Inc.
INDEX DEFINITIONS:
Barclays U.S. Corporate High Yield Index is a market value-weighted index that tracks the daily price-only, coupon, and total return performance of non-investment grade, fixed-rate, publicly placed, dollar-denominated, and non- convertible debt.
Barclays U.S. Corporate Investment Grade Index represents investment grade within the Barclays U.S. Aggregate Bond Index.
Barclays U.S. Aggregate Bond Index measures the U.S. investment grade fixed rate bond market.
Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury that have remaining maturities of one year or more.
Barclays U.S. High Yield Loans Index provides broad and comprehensive total return metrics of the universe of U.S.
dollar denominated syndicated term loans.
The S&P/LSTA Leveraged Loan Index is a daily total return index that uses LSTA/LPC Mark-to-Market Pricing to calculate market value change. On a real-time basis, the Index tracks the current outstanding balance and spread over LIBOR for fully funded term loans. The facilities included in the Index represent a broad cross section of leveraged loans syndicated in the United States, including dollar-denominated loans to overseas issuers.
The S&P 500® Index is a free-float market capitalization-weighted index of 500 of the largest U.S. companies. The indexes are calculated on a total return basis.
Credit Suisse Leveraged Loan Index tracks the investable market of the U.S. dollar denominated leveraged loan market. It consists of issues rated “5B” or lower, meaning that the highest rated issues included in this index are Moody’s/S&P ratings of Baa1/BB+ or Ba1/BBB+. All loans are funded term loans with a tenor of at least one year and are made by issuers domiciled in developed countries.
The indexes are unmanaged, their returns do not reflect any fees, expenses, or sales charges, and are not available for direct investment.
