Bank Loans: A Double-Edged Sword
Concerns about inflation and a steeper path for Fed rate hikes buoyed investor demand for floating-rate assets, but defaults are ticking higher.
Loan mutual funds and exchange-traded funds have seen net inflows of almost $4 billion year to date through April, compared to net outflows of over $15 billion for high-yield corporate bond funds. We saw similar activity in mutual fund flows in late 2016, when a 127 basis point backup in 10-year Treasury yields—from a low of 1.36 percent in July 2016 to 2.63 percent in March 2017—was accompanied by cumulative net loan fund inflows of $23 billion over the same period. Bank loans outperformed high-yield corporate bonds for the second quarter in a row on the back of strong investor demand.
Loan Fund Flows Turned Positive as Treasury Yields Rose
Bank loan mutual funds and ETFs saw inflows of $4 billion year to date through April. We saw similar activity in mutual fund flows in late 2016, when a 127-basis point backup in 10-year Treasury yields—from a low of 1.36 percent in July 2016 to 2.63 percent in March 2017—was accompanied by cumulative net loan fund inflows of $23 billion over the same period.
Source: Bloomberg, Lipper, Guggenheim Investments. Data as of 4.27.2018. LHS = left hand side, RHS = right hand side.
The Credit Suisse Leveraged Loan index posted gains across all ratings. On average, leveraged loans returned 1.6 percent for the quarter, with CCC-rated loans delivering the strongest gains of 3.6 percent, compared to 1.2 percent for BB-rated loans, and 1.6 percent for B-rated loans.
The significant increase in rates may attract investors to floating-rate loans, but it will have negative consequences for some borrowers. This is highlighted in the recent uptick in default activity, with both the 12-month trailing par and issuerweighted default rates going up in the first quarter of 2018. Nevertheless, the loan market continues to look healthy, with no widespread deterioration at this stage. Loan interest coverage stands at 3.8x compared to the 15-year average of 3.5x and historical low of 2.6x. This is largely the result of heavy refinancing activity last year, which helped drive loan spreads tighter and kept the increase in borrowing costs contained. But with refinancing activity taking a backseat to mergers and acquisitions activity this year, borrowing costs have been increasing. We do not expect meaningful deterioration in loan interest coverage until Libor reaches 3 percent or more, but as recent default activity shows, we could see some early casualties from the steady rise in borrowing costs.
Loan Defaults Are Ticking Higher in 2018 as Rates Rise
Rising rates will have negative consequences for some borrowers. This is highlighted in the recent uptick in default activity, with both the 12-month trailing par and issuer weighted default rates going up in the first quarter of 2018.
Source: S&P LCD, Bloomberg, Guggenheim Investments. Data as of 3.31.2018. Gray areas represent periods of recession.
—Thomas Hauser, Senior Managing Director; Christopher Keywork, Managing Director
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September 18, 2020
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