They’ve been around long enough: senior secure notes and collateralized loan obligations, or CLOs. For advisors who have never really paid much attention to this space, they’re like high yield bonds, only with longer settlement days, so they’re not super liquid. But if you’re looking for another way to get into fixed income, and if you’re concerned what rising interest rates might do to the total return of a bond fund, then Barings has some ideas for you.
On Tuesday, Thomas McDonnell, managing director and a high yield income fund manager at Barings hosted a webcast with RIA Channel titled “Income Strategies in the Global Loan Market”. The webinar was designed to give RIAs a chance to review the risks and rewards of holding a globally diversified portfolio of senior secured notes, most of them rated single B credit. The idea is income protection in a rising rate environment.
The webcast was available for CFP and IMCA credits. WATCH THE REPLAY NOW.
Compared to other fixed income instruments in a period of rising US rates, senior loans have outperformed their peers.
The Credit Suisse Global Leveraged Loan index rose 4.4% in 1999-00 and 13.5% in 2004-06. The Credit Suisse Leveraged Loan Index, which has been around longer, rose 10.38% in 1994 -95; 3.93% in 1999-00 and 12.64% in 2004-06. Both indices beat the Barclays US Aggregate, Barclays US Corp Investment Grade and Barclays US High Yield Corp in all three periods but one. In 2004-06, Barclays High Yield Corporate rose 17.85% by comparison in cumulative market returns.
Over time, loans have been “very consistent” in their performance, says McDonnell with ample evidence to prove it. “The only time they struggled was is 2008-09 and then again last year we saw some slightly negative performance. Plus there is low correlation to investment grade debt and equities, so you diversify your risk in high yield,” he says of loan mutual funds. “It deserves a spot in an income portfolio,” he says.
The market for loans crashed in late 2008 and early 2009, but bounced back by more than 15% later in the year. The rebound offset the losses from the previous year and were followed by more gains in 2010 (+5%), and 2011 (+2.5%).
McDonnell said that 2016 loan market returns in the US were around 10% and in Europe they were around 6%.
“We like to be global about it, because there can be different factors that can move the market in different ways,” McDonnell says about his allocation strategy. Their funds by loans priced in dollars and euros.
“The European market is smaller but it represents a very good relative value to the US,” he says. Technical imbalances may push Barings fund managers to overweight Europe from time to time.
The kicker in these loans is they are short-term and adjustable. That means if the base rate of LIBOR is 1%, these loans are averaging 463 basis points over LIBOR for U.S. senior notes and 518 basis points over LIBOR for euro-denominated ones. That gives investors yield of about 5.6% on average.
McDonnell says they are seeeing demand from institutional and retail investors.
“I think the long history of the asset class and its ability to withstand one of the biggest shocks to the economic system we’ve ever seen has been helpful,” he says. “And you can bring in over 400 baisis points over the base rate. It’s very attractive for a fixed income portfolio.”
The risk is the default rate. And they are not as liquid, so desperate sellers may have a harder time getting out or be forced to sell at an unattractive bid.
Barings believes that corporate default rates will remain low this year.
The firm has a number of fixed income products. Their loan funds include the Barings Global Floating Rate Fund (BXFAX 8,80 0,00 0,00%) and the Barings Global Credit Income Opportunities Fund (BXIAX 7,77 0,00 0,00%).
McDonnell says they take an approach similar to any typical bond fund manager when deciding which loans to buy.
Companies that issue these loans include household names like Bass Pro Shops and Ace Hardware. The float over the base rate is the key elevator pitch.
“The adjustable rate is important in this market because the coupon is in floating,” he says. “That’s a very important aspect of the asset class in a rising rate environment.”