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Loan dangers: sentiment turns on the fixed-income alternative

by Robert St George on Mar 03, 2014 at 12:49

Loan dangers: sentiment turns on the fixed-income alternative

Short duration has taken all the fixed income headlines, and justifiably so. According to data from BlackRock, last year mutual bond funds worldwide suffered outflows of more than £50 billion but short maturity products bucked that trend by taking in over £75 billion.

This aggregate number includes the shortest duration securities: loans. They haven’t attracted as much attention as bonds – Franklin Templeton became the latest to join the short duration party by launching its own product last week – but that is perhaps unfair.

The best European short duration bond fund in Citywire’s rankings over the past year, BNY Mellon Compass Euro Credit Short Duration , returned 4.1%.

The European loan market, as measured by the S&P European Leveraged Loan index, returned 8.6%. Half of this came from rising asset prices, with the remainder coupon income.

The picture was the same in the US. The best fund there, AXA US Short Duration High Yield Bond , generated 4.6%. S&P’s US leveraged loan index produced 5.3%, of which only 0.33% came from price appreciation.

Of course, this has not gone entirely unnoticed and January was a record month for loan issuance. JP Morgan reported that institutional loan issuance totalled £29.6 billion last month. The previous high for a January was £19.5 billion before the crisis in 2007.

Loan specialists Neuberger Berman and Alcentra note much of the recent issuance glut is attributable to firms refinancing their debt, but both agree that issuing loans to fund mergers and acquisitions activity is becoming increasingly important.

For investors, the attractions of loans are twofold. First, they are largely floating rate products and so afford protection against rising interest rates. Second, senior loans lie higher in the capital structure than mezzanine debt, high yield bonds and equity, so loan investors are paid ahead of these other creditors in the event of a default.

Default risk cannot be ignored, however. So what might 2014 hold on that front?

Neuberger Berman forecasts a 2% default rate in the US this year, below that market’s long-term average of 3.5%, and a 2-4% range
in Europe.

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