High yield bonds
US senior loans: Value in the current environment
CIO WM Research | 19 October 2016
Barry McAlinden, CFA, strategist, [email protected]; Leslie Falconio, Strategist, [email protected]; Philipp Schöttler, strategist; Carolina
Corvalan, strategist
What are senior loans and why are they compelling?
Senior loans (also referred to as "leveraged loans") are incomegenerating assets with a fixed maturity. They pay a regular interest
rate to investors and return the principal investment amount at the
end of their life. As such, loans share some similarities with regular
corporate bonds but have important differentiating features as well,
which we discuss in this report. Their features include the following:
• They protect against potentially higher rates in the future
through their floating-rate nature.
• Due to their senior status within a company's capital structure
and the fact that most loans are secured by company assets,
their credit risk is considerably lower than for HY bonds.
• Loan borrowers are usually medium or large firms with a subinvestment grade credit rating. Thus, the asset class is often
compared to high yield (HY) bonds.
• Senior loans are originated by banks and then sold to
institutional investors. Individual investors can get access to the
asset class via funds.
Including senior loans in a portfolio tends to improve portfolio
yield while lowering duration (see Fig. 2). In addition, loans tend
to have a low correlation to other asset classes, which improves
diversification (see Fig. 3). As a consequence of their seniority and
secured position in the capital structure and partly due to their
limited secondary market liquidity, loans tend to have a lower
return volatility compared to high yield bonds or equities; US loans
have had an annualized volatility of 6.8% over the last 15 years,
compared to 9.8% for US HY bonds and 14.7% for US equities.
Fig. 1: 3m LIBOR should soon exceed floor
values
In bps
160
140
120
100
80
60
40
20
0
Sep-13
Sep-14
Sep-15
Sep-16
Average LIBOR floor
3m LIBOR (CIO forecast)
Sep-17
3mo LIBOR (actual)
Source: UBS
Fig. 2: High yields and low duration
Yield, in %, and duration, in years
7
HY Corps
6
Loans
5
Yield
• Senior loans offer an attractive alternative to more
"traditional" fixed income investments in the current
low interest rate environment. They also protect against
potentially higher rates in the future through their floatingrate nature.
• Most US loans have a LIBOR floor of 98bps, on average, and
3m LIBOR has now risen to 88bps. Loan coupon cash flows
should soon reset higher based on our outlook for higher
LIBOR rates.
• Senior loans offer a yield of 5.9% (to 3yr) and we think
defaults will only increase very gradually. This translates into
our 12-month outlook for total returns of 3-5% for US loans,
which compares favorably vs. most fixed income alternatives.
Preferreds
4
IG Corps
3
2
CMBS
MBS
IG 1-5yr
Treasuries
Agencies
1
0
TIPS
(1)
0
1
2
3
4
Duration
5
6
7
8
Source: Bloomberg, BAML, UBS, as of 30 Sept. 2016.
Fig. 3: Correlations to US senior loans (2006 to
2016)
From -1 to 1
-1
-0.5
Treasuries
0
US Bond Aggregate
0.5
S&P 500
1
HY bonds
Source: Bloomberg, BAML, UBS, as of 30 Sept. 2016.
This report has been prepared by UBS Financial Services Inc. (UBS FS) and UBS Switzerland AG. Please see
important disclaimers and disclosures at the end of the document.
High yield bonds
Loan features in detail
The most important features to consider when investing into senior
loans are their: 1) very low interest rate duration due to their
floating-rate character; 2) lower credit risk; 3) higher liquidity risk
and 4) call risk.
Fig. 4: Last 10 years average annualized returns
Returns (LHS) and standard deviation of returns
(RHS)
20%
35%
30%
15%
1. Duration: The coupon rate on senior loans is floating, which
means that it is reset regularly based on the development of a shortterm benchmark rate plus a stated credit spread. In the case of
US loans, the benchmark is usually the 3-month USD LIBOR and
the reset is done every 45 to 60 days on average. As a consequence, rate duration of senior loans is close to zero and the interest
rate risk is thus very low, which is especially beneficial in times of
rising rates. A recent development since the financial crisis has been
the introduction of LIBOR floors, or minimum reset rates. In these
cases, the coupon is fixed until the market LIBOR rate exceeds the
floor level, which moderately increases the loan's duration. Approximately 90% of the US leveraged loan index currently contains a
LIBOR floor of 98bps, on average.
25%
10%
20%
5%
15%
10%
0%
5%
-5%
Fall
Rise
Rise modestly
Source: BAML, Bloomberg, UBS, as of 30 September
2016. Note: The interest rate regime refers to changes
in the 10-yr UST yield
Fig. 5: Loans rank senior within a company's
capital structure
Priority of claims of different securities
Due to their floating-rate nature, loans tend to perform best in
periods when interest rates rise (or remain flat, as loans usually still
provide a good yield pick-up). Loans provided returns of 8% historically when interest rates were rising, outperforming most fixed
income classes (see Fig. 4). However, when rates fell, loans tended
to lag in performance.
2. Credit risk: Senior loans are typically secured by the borrower's
assets. As such, they have a higher ranking within a company's
capital structure than senior unsecured bonds (see Fig. 5). Thus, in
case of a default, this part of the debt will usually be first in priority to obtain recovery values. Furthermore, loans usually involve
protective covenants providing the lender with forceful control over
the borrower, although covenant protection has eroded over the
past years. These features lead to lower default rates as well as
higher recovery values for loans relative to HY bonds (see Fig. 6). The
average annual credit loss over the last 20 years was 1.3% on US
loans and 2.8% on US high yield bonds. In summary, the credit risk
of senior loans is considerably lower than for HY bonds. However,
the leveraged nature of issuers does make the loan asset class highly
sensitive to credit cycle fluctuations.
3. Liquidity: Senior loans are originated by banks and then traded
"over the counter" (OTC) between different banks and mostly collateralized loan obligations (CLOs) and loan fund managers. Senior
loans provide less liquidity than even HY bonds. While this feature
is actually a useful protection for long-term investors, it has to be
considered carefully before making an investment into loans. For
investors who have a longer investment time horizon, the illiquidity
premium that is typically offered by loans for compensation is an
attractive return component.
0%
IG Corps ABS FRN
FRN
Return volatility (rise modestly) (RHS)
Treasuries IG Corps HY Corps Sr. loans
Senior loans
Senior unsecured bonds
Subordinated bonds
Tier 1 / hybrid bonds
Equity
Source: UBS
Fig. 6: US loan vs. US HY default rate
Trailing 12-month default rates, in %
16%
14%
12%
10%
8%
6%
4%
2%
0%
06
07
08
09
10
11
12
13
14
Loan default rate
HY bond defalut rate
Loan average
HY bond average
15
16
Source:Moody's, UBS, as of 30 September 2016
4. Call risk: The majority of loans are immediately callable, although
some have a USD 101 “soft call” where the issuer has to pay a USD
1 penalty to refinance at a lower rate for the first six months or
one year following issuance. Many issuers have taken advantage of
strong market conditions and have “repriced” their loans to lower
credit spreads by using this continuous call feature. Similar to the
CIO WM Research 19 October 2016
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High yield bonds
HY bond market, call features will constrain the price appreciation
potential of loans during strong market conditions.
Loan market characteristics
The US institutional loan market has been growing steadily, with
the amount outstanding of the S&P US Leveraged Loan Index rising
from USD 90 billion in 1999 to USD 890 billion to date. Institutional investors and CLOs comprise the majority of the US senior
loan ownership structure. However, retail investors constitute a significant source of US loan demand, accounting for roughly 20% of
primary allocations (see Fig. 7).
In terms of rating, US loans are rated below investment grade but
10% of the market is BBB rated (see Fig. 8). Sector-wise, the loan
market has a large exposure to the technology, healthcare, services
and media sectors (see Fig. 9). It's also worth noting that commodity-sensitive sectors have a relatively small weight in the US.
Since short-term interest rates have moved to record low (or even
negative) levels in recent years, loan issuers have started to include
interest rate floors in their loan contracts. Theses floors make sure
that coupon payments will not fall below a certain threshold – often
set at 100bps plus the quoted spread – protecting investors from a
certain degree of falling rates. On the other hand, this feature introduces some rates duration to the asset class, as coupon payments
will only start to "float" once the interest rate floor is reached. By
now roughly 90% of outstanding US loans have a LIBOR floor of
98bps, on average.
Outlook & recommendations
The US credit market has broadly benefited from a continued search
for yield in the past months, as global monetary policy remains
accommodative and US macro data points to resilient economic
growth despite late-stage cycle trends, including tightening lending
standards.
Against this backdrop, US CLO demand has firmed from levels seen
earlier in the year. Average CLO issuance volume was USD 6bn in
the April to August period and rose to USD 8bn in Sept. While
the CLO market has picked up from low levels, market expectations for CLO issuance this year have declined to about USD 45bn
from USD 70bn, compared to USD 99bn of CLO issuance last year.
We believe CLO issuance should remain steady enough to maintain
supply/demand balance, even as managers consolidate along with
new risk retention rules that go into effect next year.
Retail flows, the other main source of US loan demand, have also
shown modest inflows recently. Most US loans have a LIBOR floor of
98bps on average, so they will have a fixed duration exposure until
short-term rates reach 0.98%. LIBOR has slowly crept up towards
0.88% following the Fed's first rate hike in December 2015 and
the influence of money market reform rules. CIO expects the Fed
to raise rates this December and for two more rate hikes next year.
This should support loan demand as coupon levels would then be
in a position to reset higher.
Fig. 7: Loan investors by type
In %
Loan Mutual Funds
22%
Insurance Co.
6%
CLO
61%
Hedge, Distressed &
HY Funds
10%
Finance Co.
1%
Source: S&P LCD, UBS, as of 30 September 2016
Fig. 8: S&P US loan index ratings breakdown
In %
20%
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
BBB
BBB- BB+
BB
BB-
B+
B
B-
CCC+ CCC CCC-
Source: S&P LCD, UBS, as of 13 October 2016
Fig. 9: S&P US loan index sector breakdown
In %
14%
12%
10%
8%
6%
4%
2%
0%
Source: S&P LCD as of 13 October 2016
CIO WM Research 19 October 2016
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High yield bonds
We expect the US loan default rate to increase towards its longterm average of 3% in the next 12 months from 2.0% currently as
the credit cycle advances, with an expected recovery rate that falls
short of the long-term average recovery rate of 70% for loans. This
stems from the concentration of energy and metals firms among
the defaulted issuers that offered low recovery values in the recent
past.
Over the next 12 months, we expect senior loans to deliver total
returns of 3-5%, driven mostly by carry. Even if interest rates were
to remain at their current low levels for longer, we believe that loan
valuations are attractive at current levels, offering a yield pick-up
of 4% over investment grade corporate bonds with maturities of
1-5 years.
Due to the speculative-grade nature of the issuers which borrow in
the loan market, we recommend that senior loans be considered
by investors with an adequate risk profile, who would otherwise
be comfortable investing in HY bonds. Additionally, the secondary
market for loans can be illiquid at times. Investors should thus be
comfortable with some illiquidity risk. We think that senior loans
are an attractive addition to a well-diversified taxable fixed income
portfolio, providing for strong risk-adjusted returns, an appealing
yield as well as diversification benefits.
Fig. 10: US HY bond less senior loan yields
In bps
350
300
250
200
150
100
50
0
11
12
13
All loans
14
15
16
B rated loans
Source: S&P LCD, UBS, as of 7 October 2016
Fig. 11: US senior loan credit spreads
In bps
3,000
2,500
LIBOR +
In the US, new large loans had an average gross debt/EBITDA level of
5.0x in the first half of 2016, slightly up from 4.7x in 2015. US regulators have highlighted that leverage above 6x would be a problem,
capping the amount of deals with excessive leverage. Interest coverage decreased from 4.4x in 2015 to 3.6x so far this year. The percentage of covenant-lite loans continues to remain elevated.
2,000
1,500
1,000
500
0
06
07
08
09
10
Loan spread to maturity
11
12
13
14
15
Loan spread to 3yr average life
16
Source: S&P LCD, UBS, as of 7 October 2016
CIO WM Research 19 October 2016
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High yield bonds
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