With low interest rates across global markets, a number of investors are turning to credit assets to enhance returns. While
PIMCO remains constructive on credit
overall, there are signs of modest deterioration in fundamentals within certain sectors, and valuations are at or near one-year highs across much
of the credit universe. Investors will need to start thinking outside the box to enhance returns in the current environment of flatter credit yield
curves and fairly low compensation for risk across asset classes.
Fortunately, the credit “toolkit” extends beyond simply reaching down in credit quality. For sophisticated investors with longer-term investment horizons,
there may be material benefits to applying moderate leverage (for example, 2x to 3x assets-to-equity) to a portfolio of high-quality, senior secured bank
loans. While some investors may view leverage with apprehension, we believe the current low cost of leverage, combined with the historically low volatility
of high quality senior secured bank loans1 provides a unique opportunity to enhance return potential without sacrificing credit quality or
incurring significant structural leverage. The floating rate nature of the bank loan market also mitigates interest rate risk, providing a measure of
insulation against the potential downside in applying leverage to the sector.
Standing at the front of the line
The bank loan market is composed of senior secured loans to corporate borrowers, mostly based in the U.S. The sector sits between investment grade and high
yield bonds on the risk spectrum. Similar to high yield bonds, bank loans are below investment-grade credits, but they have two key distinctions: loans
typically enjoy secured status unlike most high yield bonds, and they are floating rate instruments, which pay higher (or lower) coupons as interest rates
rise (or fall). 1
As measured by the monthly deviation of returns on the Credit Suisse Leveraged Loan Index Bank loans are typically secured by assets owned by the issuer, which means that bank loan investors generally stand in front of high yield bond investors
in the case of default. Importantly, this has resulted in higher recoveries for bank loans in the event of default or restructuring. Historically, average
recoveries on loans have run near 70% compared to those on high yield bonds of less than 50% (see Figure 1).
The priority, secured position of bank loans has contributed to their lower volatility compared with many other credit products, including high yield and
emerging market bonds. Positioning a portion of a portfolio in loans can therefore be a good way to reduce the risk of a higher-yielding credit allocation.
And as we enter the eighth year of the economic recovery, taking positions higher up in the capital structure may be prudent.
Floating Rate Nature of Bank Loans
The floating rate coupons offered by bank loans are based on a yield spread over Libor, and they adjust every one to three months. It is important to know
that the majority of bank loans outstanding have Libor “floors,” so the coupon only begins to increase once Libor exceeds a minimum “floor” rate (on
average, this floor rate is 1%). Given Libor’s low level today, bank loans may not provide a significant increase in income relative to high yield bonds,
but they may provide limited downside when bond prices fall and meaningful upside once Libor exceeds floor rates. This is why the loan market has
historically exhibited strong performance during periods of rising rates.
Leveraging the opportunity
Given the strong performance across fixed income markets in 2016 to date, investors seeking to enhance returns are faced with a dilemma: Are they best
served by going down in credit quality, moving down the liquidity spectrum to capture “liquidity premiums,” or adding moderate levels of leverage?
While PIMCO believes there are meaningful benefits to moving down the liquidity spectrum into opportunistic assets, such as real estate and credit-related
opportunities, many investors are unwilling to sacrifice meaningful amounts of liquidity. From this perspective, a moderately leveraged approach to bank
loans can present an attractive option. With the benefits of structural seniority, limited interest rate risk and attractive financing levels, modestly
leveraged bank loan strategies have the potential to help achieve attractive yields in the current environment, without sacrificing a material amount of
liquidity or significantly increasing volatility.
At current levels, financing costs to apply leverage to high quality bank loans are historically low.
While there are several ways to apply leverage to bank loans, total return swaps can be cost effective and efficient, and also allow active managers to
hand-pick credits and selectively tailor leverage to match the individual credit risk of each bank loan. (For context, current costs on total return swaps
on bank loans are roughly Libor plus 100 bps‒125 bps.) We believe the most prudent approach includes the flexibility to actively manage exposure between
bank loans and high yield bonds, overall leverage levels and security selection within the bank loan and high yield market.
Our approach is typically to lever higher-quality, lower-volatility bank loans that can mitigate mark-to-market volatility during risk-off market
environments and reduce the risk of loss when default rates increase across corporate credit assets. It should also be noted that these moderately
leveraged portfolios are generally not compatible with daily liquidity portfolios, and typically work best within a monthly liquidity format.
Where can a leveraged bank loan strategy fit in a portfolio?
Leveraged bank loan strategies can play a variety of roles in a portfolio:
- Return enhancement versus traditional bank loans. Given low absolute yield levels across credit markets, applying leverage to select,
higher-quality bank loans can provide a potential boost to returns over traditional bank loan strategies, without applying leverage to an entire bank loan
- De-risking tool versus equities. As many investors reduce their return expectations for equities, credit can provide an attractive
alternative with lower volatility. Leveraged bank loans can help produce attractive yield potential, while keeping volatility well below that of
traditional equity indexes.
- Substitute for CLO (collateralized loan obligation) debt. Demand for CLO debt has been robust in recent years even amid historically
high issuance. While the CLO may be the most well-known type of leveraged loan portfolio and can offer attractive returns over time, there may be drawbacks
for more liquidity-constrained investors, including lack of liquidity in the secondary market, price volatility based on weak secondary market technicals
and a long lock-up of capital.
- Alternative to high yield bonds. Leveraged bank loans can be a compelling complement to or substitute for high yield bonds,
specifically short-dated high yield bonds. Applying moderate leverage to a senior secured asset can potentially provide similar returns, with superior
downside cushion in weaker credit market environments.
The risks in leveraged bank loans
While bank loans can provide a greater cushion within the leveraged credit universe, the bank loan sector in general can be volatile at times and has had
cycles of aggressive underwriting. Applying moderate leverage to the sector can potentially enhance returns during periods of low volatility, but it can
magnify downside risks during periods of elevated volatility or defaults (see Figure 2). Against this backdrop, in our view, active management of leverage,
security selection and overall credit exposure is critical to navigating full market cycles.
Moderate leverage in bank loans: a credit tool
As many investors struggle to achieve their return targets in the current environment, tools for enhancing returns often include moving out on the
liquidity spectrum and going down in credit quality. Moderately leveraged bank loan strategies can allow investors to maintain a fair degree of liquidity
and improve return potential without going down in credit quality. In addition, their senior secured nature and floating rate coupon structures mean bank
loans can potentially offer a downside cushion to a bond portfolio in weaker credit environments and rising interest rate environments. Applying leverage
entails risk, but it can serve as a useful tool when applied prudently to higher-quality credits.