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
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
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
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
Muzinich & Co. referenced herein is defined as Muzinich & Co., Inc. and its affiliates. This document has been produced for information purposes only and as such the views contained herein are not to be taken as investment advice or as an offer to buy or sell or invitation to engage in any investment activity. Opinions are as of date of publication and are subject to change without reference or notification to you. Past results do not guarantee current or future performance. Opinions and statements of financial market trends that are based on market conditions constitute our judgement as at the date of this document and are subject to change. They are considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. Certain information contained in this document constitutes forward-looking statements; due to various risks and uncertainties, actual events may differ materially from those reflected or contemplated in such forward-looking statements. Nothing contained in this document may be relied upon as a guarantee, promise, assurance or a representation as to the future. Certain information contained herein is based on data obtained from third parties and, although believed to be reliable, has not been independently verified by anyone at or affiliated with Muzinich and Co., its accuracy or completeness cannot be guaranteed. Risk management includes an effort to monitor and manage risk but does not imply low or no risk. Issued in the European Union by Muzinich & Co. (Dublin) Limited, which is authorized and regulated by the Central Bank of Ireland. Registered in Ireland No. 625717. Registered address: 16 Fitzwilliam Street Upper, Dublin 2, D02Y221, Ireland. Issued in Switzerland by Muzinich & Co. (Switzerland) AG. Registered in Switzerland No. CHE-389.422.108. Registered address: Tödistrasse 5, 8002 Zurich, Switzerland. Issued in Singapore and Hong Kong by Muzinich & Co. (Singapore) Pte. Limited, which is licensed and regulated by the Monetary Authority of Singapore. Registered in Singapore No. 201624477K. Registered address: 6 Battery Road, #26-05, Singapore, 049909. Issued in all other jurisdictions (excluding the U.S.) by Muzinich & Co. Limited. which is authorized and regulated by the Financial Conduct Authority. Registered in England and Wales No. 3852444. Registered address: 8 Hanover Street, London W1S 1YQ, United Kingdom. Muzinich & Co., Inc. is a registered investment adviser with the Securities and Exchange Commission (SEC). Muzinich & Co., Inc.’s being a Registered Investment Adviser with the SEC in no way shall imply a certain level of skill or training or any authorization or approval by the SEC.