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Loan dangers: sentiment turns on the fixed-income alternative

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.

The group’s confidence in those relatively low rates is based on a dearth of imminent maturities, with only 2.6% of institutional loans falling due in 2014-15, and an improvement in the quality of issuance since the crash.

None of the most dangerous types of loans – those with interest coverage of less than 1.5 – were issued last year.

What defaults there are tend also to be telegraphed in advance and reflected in the loan’s price. In the US last year, 11 issuers defaulted on almost £7 billion of paper. Two-thirds of that was accounted for by five of the 11 issuers, specifically four yellow pages businesses and one textbook publisher.

More ominous, however, is another trend: ‘covenant light’ loans. By Neuberger Berman’s reckoning, 57% of US issuance in 2013 was ‘covenant light’ and such loans now represent 46% of the market.

The firm notes there was less interest in these loans in Europe, but tips an increase in 2014 as investors chase yield.

David Coombs, head of multi-asset investments at Rathbones, recently backed senior loans but is now cooling on them.

‘Our appetite is dwindling slightly in this asset class. It’s got very “me too” and very consensual in the past 12 months,’ he says.

‘There have been a lot of senior loan funds being launched in the open-ended space, which we don’t think is appropriate for loans. It always makes me nervous when fund groups all start launching funds in a hot asset class. I think we will actually be reducing senior loans as yields rise,’ he adds.

Matt Eagan, a manager in the Loomis Sayles fixed income team, believes loans have their uses. He describes the sector as ‘a good place to hide out’ when high yield is expensive, as it is now.

‘If you can earn 4% in 2014, you will probably be happy,’ he said. But he is also wary of loans’ strong correlation to high yield.

Todd Youngberg, head of high yield at Aviva Investors, points out that the average price of a high yield bond is now almost 5% above par, limiting the scope for further capital gains.

He adds the global high yield bond market began 2013 with a yield-to-worst of 6.13%, which had slipped to 5.34% by the end of January.

The quality of underwriting is a final issue for Eagan. ‘When there is demand for paper, Wall Street creates it,’ he warns. And this demand for loans, at least partly due to the pursuit of past returns and unattractiveness of traditional fixed income assets, worries him.

‘I see people buying bank loans for the wrong reasons. I wince when I hear why people are buying them.’

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