For nearly a decade, the U.S. equities market reigned supreme. A consistent bull market, buoyed by strong economic growth and historically-low interest rates made stocks the investment headliner. But with the Dow plummeting over 1,000 points in a mere two days, and interest rates continuing to rise, the once-overlooked credit market is showing strong signs of potential.
The loan market specifically is a yielding, lower volatility alternative to equities, and is an asset that benefits from rising interest rates. It is no coincidence that if looking at the long term performance of loans over the past 20 years, there’s been only one down year which was during the depths of the Great Financial Crisis.
Most investors are familiar with traditional fixed income markets: investment grade bonds, high yield bonds, municipal bonds and emerging market bonds. Credit applies to a range of investments, but is most closely aligned with loans. Loans are issued by the same issuers, purchased by the same investors, brought to market by the same banks and rated by the agencies as traditional bonds. The key difference between loans and traditional bonds is that loans include features that provide for secured collateral and floating rate coupons. In other words, this means loans possess security, are interest rate insensitive and pay as much as, and more than, traditional fixed rate bonds.
The majority of the more than $1.1 trillion loan market is comprised of institutional investors. Approximately 50% of loans are held by closed-end vehicles called Collateralized Loan Obligations (CLOs). These vehicles are analogous to banks. They issue equity and debt securities and purchase loans with the proceeds. The nature of these structures has CLO managers focused more on credit and less on price action. Another 38% of the market is owned by institutional investors in fund and separate account formats. Only 12% of the market is represented by retail mutual funds. This is a much different investor landscape as compared to high yield funds, where retail investors hold over 28.50% of the market.
The importance of the loan market makeup should not be overlooked. CLOs provide a stable base of capital this market. The small percentage of retail dollars means that retail flows, which are traditionally fickle, are less impactful versus other credit asset classes where retail investors represent a higher proportion, and less stable base.
In this post-crisis world, the structure and liquidity profile of many markets has been altered, in part due to regulatory change. Today, understanding liquidity is a key component of risk management. While it may be the case that liquidity for middle-market or direct loans is less robust however, the broadly syndicated loan market is very liquid. In our experience, there is no material difference in loan market liquidity versus the traditional fixed income credit markets these days. Could that change? Of course. Our most recent case study with market indigestion was during the first quarter of 2016, a time when many referred to markets as less liquid. During this period, liquidity existed for loans albeit at lower levels and at lower prices. However, loans were tradable with a lower drawdown profile than equities or bonds.
In the current market environment, loans provide investors with essentially a cheaper risk profile. With high prices across many financial markets, loans continue to provide an excess spread return to investors (excess spread is the amount an investor gets paid after expected credit losses). Today, excess spread is approximately 320bps. Viewed from this risk/reward perspective, senior, secured floating rate loans are the cheapest house on the credit block today and pay more excess spread than fixed-rate, unsecured, high-yield bonds.
There are several reasons that this market is performing well, and is positioned to continue on this path. Key among them are fundamentals. Credit continues to perform from an earnings and debt service perspective, and the US economy is doing quite well by many measures. Defaults also remain low. Also impacting this market positively are technicals. Demand is high, with many investors who remain exposed to traditional fixed income bonds seeking alternatives to protect their portfolios from interest rate and volatility risk.
Loans remain an untapped market for retail investors and should not be overlooked as part of a diversified portfolio allocation. They provide respite from many risks faced by investors today including interest rate risk, volatility risk and valuation risk. When market volatility is quickly escalating, loans are an asset that investors should not overlook.
Stan Sokolowski is senior portfolio manager of the Catalyst Floating Rate Income Fund (CFRIX).