While U.S. bank loans posted a modestly negative total return in 2022, they remained one of the better performing asset classes as a hawkish Federal Reserve, high and persistent inflation, and recession fears drove double-digit declines across other fixed income sectors. This outperformance was partly due to the floating-rate nature and short duration of the asset class, which made them far less sensitive to the sharp rise in Treasury yields and served as a source of capital preservation during extreme volatility. Still, investors have been pulling money from bank loan funds in recent months, which may partly be driven by a misunderstanding of the timing of rate resets. Loan yields have recently begun resetting higher alongside the sharp rise in base rates and now offer a compelling pickup in yield over most other fixed income asset classes.
Following 17 consecutive monthly inflows totaling $17.8 billion, fund flows into loan mutual funds turned sharply negative in May and have yet to recover. As inflation ticked higher and the Fed grew more hawkish, investors poured money into floating rate loans funds as a potential hedge against rising interest rates. But as rates continued to rise, investors soured on the asset class, withdrawing $36.5 billion from loan funds over the past eight months. (Figure 1) We believe this reversal could partly be driven by a misunderstanding of the mechanics of bank loan rate resets and when investors typically begin to see the benefits from rising interest rates.
Lipper, JP Morgan as of January 4, 2022.
A Two-Step Trade
Investors in floating rate mutual funds typically seek capital preservation in rising rate environments, as well as higher current income as rates rise and dividends grow. We see these as two separate features of the asset class and, thus, as a two-step trade.
The first phase is capital preservation as fixed rate products with longer durations sell off in a rising rate environment. This first phase played out as expected in 2022 as bank loans materially outperformed nearly every other asset class. (Figure 2).
Credit Suisse as of December 31, 2022.
The asset class is now in the middle innings of the second phase, which consists of larger dividends as rising interest rates lead to higher all-in loan yields. This second phase is just now beginning as the impact of rate resets start to flow through to investors in the form of higher coupon payments. With loan coupons having now risen to over 8% and the yield-to-maturity to over 10%, loan investors are only now beginning to reap the benefits of higher interest rates—meaning that anyone who pulled money out of loan funds last year may have left the party before dinner was served. (Figure 3)
Credit Suisse as of January 10, 2022.
An Inherent Delay
Floating rate funds are generally invested in broadly syndicated bank loans, which pay a coupon on top of a benchmark interest rate. Bank loan issuers have the ability to choose from 1-, 3- or 6-month LIBOR/SOFR. The total coupon on a floating rate bank loan consists of this base rate (which floats) plus a fixed spread.1 Since bank loan issuers have the option to choose 1-, 3- or 6-month LIBOR/SOFR, there is an inherent delay in increasing distributions to floating rate fund investors. As the issuer’s contracts roll off and reset at higher rates, it pays a higher coupon which, in turn, leads to increased dividends for floating rate fund investors.
LIBOR and SOFR sustained sharp spikes in 2022 and we expect both to continue to rise alongside expected Fed rate hikes into early 2023. These higher base rates should be a tailwind for total returns even as they potentially introduce more stress for highly leveraged issuers. Bank loan issuers have seen their costs of capital rise meaningfully over the past year, which will likely pressure cash flows in 2023 and potentially set the table for a rise in defaults. Still, we believe the net effect will be positive, with any impact from a decline in prices or credit losses to be more than offset by currently high all-in current coupons. Amid this environment, we expect loans to post positive total returns of 6-6.5% in 2023.
A Compelling Pick Up In Yield
With average loan prices in the low- to mid-90s and dividend distributions increasing as base rates rise, we believe the current entry point is now more attractive now than in early 2022. With LIBOR/SOFR nearing 5% and loan prices well below par, loan yields now offer a compelling pick up in yield over other fixed income assets and are currently outpacing high yield bond yields by approximately 133 bps. (Figure 4)
Credit Suisse as of January 11, 2022. Loan Yields expressed as yield-to-maturity. High Yield Bond Yield expressed as yield-to-worst.
That said, credit selection is becoming more critical as the loan market is of lower quality than in prior cycles, with issuers carrying higher leverage and lower interest coverage. Ratings downgrades have started to pick up and we currently expect loan defaults to rise to 4-4.5% by year-end 2023 as higher interest rates, more restrictive capital markets, and a lower growth outlook take a toll on lower-quality issuers.
Therefore, credit selection, with a bottom-up focus on a company’s competitive positioning, end-market exposure, fixed/variable cost structure, and ability to manage a higher interest burden, will likely be a key differentiator among credit managers. With the avoidance of defaults expected to be the largest driver of alpha over the next 12-24 months, strong credit research and financial modelling capabilities, as well as deep industry experience, will likely be more critical than ever.
1Because SOFR is lower than LIBOR, some bank loan issuers have adopted a Credit Spread Adjustment (CSA) of an additional 10-25 bps if utilizing SOFR.
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