2013
The case for leveraged loans
Lynn Hopton, Senior Portfolio Manager
As the saying goes, what goes up must come down.
But does what’s down have to go up again? In this case,
we are talking about interest rates. Most investors believe
interest rates will eventually rise again, but the questions
are, “When will they go up, by how much, and over what
time frame?” The implications for asset allocation
and portfolio construction are material. Clearly, debt
instruments have a place in most investor’s portfolios.
However, the duration risk associated with many traditional
fixed-income instruments is a cause for caution, particularly
in today’s low interest rate environment.
One way to balance out that risk is to allocate a portion
of one’s debt holdings to floating rate leveraged loans.
What are leveraged loans?
Leveraged loans are originated by banks and sold to
institutional investors, including mutual funds. The loans
are made to large corporate issuers, generally of less-thaninvestment-grade credit quality. Corporations use these
loans to fund acquisitions, operations, dividend payments
and other strategic initiatives. The loans almost always
have floating rates, meaning they pay a given amount (the
credit spread) over a benchmark interest rate. In most
cases the benchmark is LIBOR (the London Interbank
Offered Rate). Typically, the longest term LIBOR rate that
corporate issuers may select is the three-month rate (in
some cases, they may select six-month LIBOR). Therefore,
a leveraged loan’s duration is generally less than three
months (versus more than four years for most corporate
high-yield bonds).
In addition, unlike high-yield bonds, leveraged loans are
generally secured by all or most of the assets of a
company. This results in higher recoveries than unsecured
bonds in the event that a corporate issuer’s business
deteriorates and the issuer faces bankruptcy or an
out-of-court restructuring.
Currently, LIBOR is very low and has been since
mid-2009, particularly compared with historical levels.
As a result, banks have structured most loans issued
since that time with LIBOR “floors.” LIBOR floors ensure
that investors in the loans receive some minimum base
level of compensation in addition to the credit spread the
loan pays. The average LIBOR floor in the loan market is
a little more than 100 basis points, or 1%.
What happens to leveraged loans in a rising
interest rate environment?
Although it is not always the case that LIBOR moves in
lock-step with longer term interest rates, there is certainly
a very positive correlation. A fixed coupon investment
declines in price when interest rates rise (all else equal).
The magnitude of the decline is directly dependent on the
duration of the asset. In the case of floating rate loans,
however, the investment’s price will (all else equal)
remain relatively constant due to its very low duration,
particularly after LIBOR has increased beyond the 1% range
(i.e., beyond the level of the average LIBOR floor). In fact,
historically, an increase in LIBOR rates leads to higher
demand for loans as their absolute yield increases, thus
pushing loan prices higher. We saw this phenomenon in
the 1999–2000 timeframe and again in 2005 through
early 2007.
Don’t forget about the fundamentals, too
As tempting as it is to look at leveraged loans as a panacea
to rising rates, it is imperative to evaluate the issuer’s credit
fundamentals. These loans are made to issuers of lessthan-investment-grade credit quality. And although the case
can be made that loan prices tend to be less volatile than
high-yield bond prices due to their shorter duration and
higher priority in the capital structure, leveraged loan prices
can be volatile given the credit profile of the loan issuers.
On the negative side, the rapid earnings growth many
corporate issuers experienced in 2011 and through most
of 2012 is likely coming to an end. With the economy
slowing, revenue growth has decelerated. In addition,
most corporations can make few additional cuts to reduce
costs at this point. In fact, to the contrary, more issuers
are finally beginning to hire again and invest in their
businesses. Although this is a positive over the long-term,
it does put a damper on increases in earnings in the
near-term.
Nevertheless, we do not believe there will be any material
increase in default rates for the below-investment-grade
market unless the situation in Europe gets precipitously
worse or there is a continued and sustained gridlock in
Washington over taxes and spending cuts. Most high-yield
issuers are still in a position of strength given their lower
relative leverage, high cash balances and long debt
maturity profiles.
Our conclusion
Although we cannot predict exactly where interest rates will
go and when, we believe at some point the direction will be
up. Leveraged loans, with LIBOR floors, relatively attractive
credit spreads and sound fundamentals, offer investors
both a reasonable current return for the level of risk along
with a meaningful offset to the risk of rising rates versus
traditional fixed-income investments.
In today’s environment, the default rate is quite low by
historical standards, at about 1% per annum. We believe
the leveraged loan asset class as a whole remains
generally healthy, with few looming defaults visible over the
next several quarters. In addition, the increasing amount of
loans being issued at shorter durations gives further
credence to the argument for continued low default rates.
Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.
Important disclosures
The views expressed are as of January 2013, may change
as market or other conditions change, and may differ
from views expressed by other Columbia Management
Investment Advisers, LLC (CMIA) associates or affiliates.
Actual investments or investment decisions made by CMIA
and its affiliates, whether for its own account or on behalf
of clients, will not necessarily reflect the views expressed.
This information is not intended to provide investment
advice and does not account for individual investor
circumstances. Investment decisions should always be
made based on an investor’s specific financial needs,
objectives, goals, time horizon and risk tolerance. Asset
classes described may not be suitable for all investors.
Past performance does not guarantee future results and
no forecast should be considered a guarantee either.
Since economic and market conditions change frequently,
there can be no assurance that the trends described here
will continue or that the forecasts are accurate.
Securities products offered through Columbia Management
Investment Distributors, Inc., member FINRA. Advisory
services provided by Columbia Management Investment
Advisers, LLC.
Investment products are not federally or FDIC-insured,
are not deposits or obligations of, or guaranteed by any
financial institution, and involve investment risks including
possible loss of principal and fluctuation in value.
© 2013 Columbia Management Investment Advisers, LLC. All rights reserved.
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