Viewpoint | May 25, 2021
The Benefits of Syndicated Loans in a Rising Rate Environment
As interest rates trend higher, should investors consider an allocation to syndicated loans?
As rates declined from the fourth quarter of 2018 until the end of 2020 the syndicated loan market, as a floating rate asset class, became unpopular with investors. As a result, over that period the market saw significant retail outflows of approximately US$86 billion.1
This year, as 10-year Treasury yields have moved higher, investors have returned to the loan market and are underpinning a rally which, in our view, could make syndicated loans one of the best-performing and least volatile corporate credit asset classes of 2021.
Looking at retail flows, Lipper data shows inflows totaling US$16 billion in the first quarter of 2021.2 However, retail remains a relatively small part of the syndicated loan market (and the European loan market is not directly accessible to retail).
Fig. 1 – Retail Fund Flows and 10-Year Treasury Yields
Source: JP Morgan High Yield Bond and Leveraged Loan Market Monitor, ICE BofA ML Current 10-Year US Treasury Index (GA10). As of March 31st, 2021
Collaterised loan obligations (CLOs) are truly the determining technical driver in the syndicated loan market and are also a floating rate product providing rates protection. This year has seen US$54 billion of CLO new issuance (US$148 billion if you include refinancing/reset activity) as investors sought refuge from rates moves in this market, which is now approaching US$785 billion in size.3 We also see increased interest from international investors as hedging costs have declined in recent years.
Fig. 2 – 2021 Seeing Fastest Pace of CLO Supply in Years
Source: Credit Suisse, LCD, as of May 12th, 2021
At the same time, the fundamentals of the underlying borrowers in the loan market have continued to improve. It is worth pointing out that the market has an insignificant amount of energy exposure, and most other industries affected by the pandemic have recovered strongly from their 2020 troughs.
The current earnings season is producing what we believe to be generally strong corporate results and credit metrics are continuing to improve. As most of the default activity in 2020 began a year ago, the trailing 12-month default rate has now begun to decline precipitously, with JP Morgan showing a 109 basis point month-on-month decline in April.4 This takes default rates to 2.25%, below the long term average, and we expect this trend to continue in coming months. Similarly, rating agency upgrades now outpace downgrades at the fastest rate since 2012.5
You would expect the twin forces of positive fundamentals and strong technicals to have taken any value out of the market already, but in our opinion, this is not the case. While loan spreads have gone through long term historical averages, they still offer compelling absolute value and relative value when compared to high yield. In our opinion loans could tighten further from here if fundamentals continue to improve and investors continue to be concerned about inflation and the direction of rates.
Fig. 3 – Discount Margin (3 year) of US Syndicated Loans versus US HY Spread to Worst
Source: Bloomberg and Credit Suisse Leverage Loan Index (CSLLI). Data as of April 30, 2021. ICE BofA ML US Cash Pay High Yield Constrained Index (JUC4).
So far, the moves in rates have been confined to the longer part of the curve. Indeed, short term Libor has tightened so far in 2021, although loan investors are largely protected from these moves by universally present Libor floors.
However, with continued inflation expectations and a US economy which is enjoying a government stimulus boosted expansion, it may not be very long before the short end begins to rise and the curve flattens – bringing additional coupon to syndicated loan investors.
It is for these reasons that we believe syndicated loans could be one of the best-performing corporate credit asset classes in 2021.
1. JP Morgan High Yield Bond and Leveraged Loan Market Monitor May 3rd, 2021
2.JP Morgan High Yield and Leveraged Loan Morning Intelligence, April 2nd 2021
3.JP Morgan CLO Weekly New Issue Data Sheet May 10th, 2021
4.JP Morgan Default Monitor May 3rd, 2021
5.S&P LCD article May 11th, 2021
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