A Bank Loans Pull-Back? Not So Fast.
June 13, 2014
After nearly two years of inflows, U.S. retail bank loan funds have seen outflows in recent weeks. Is this an early sign of potential hard times? Not in our view.
What has caused the recent reversal in demand for bank loans from U.S. retail investors? We don’t believe that it's tied to underlying fundamentals, which in our opinion remain attractive. U.S. corporate profits have been generally solid, with Thomson Reuters reporting that first quarter earnings growth for the S&P 500 increased a solid 5.5%. In addition, cash flow growth is allowing the vast majority of companies to meet their debt obligations. What's more, the capital markets are open and refinancing activity has pushed out maturity dates, helping to keep defaults generally low. According to JP Morgan, the leveraged loan default rate at the end of May was just 1.35%.
So what's behind the shift in retail investor sentiment? This year's surprising decline in 10-year Treasury yields has retail investors less concerned with near-term increases in interest rates. And given spread compression, loan coupons aren't as attractive as compared to 12–18 months ago. But we expect demand to resume sooner rather than later. Here's why.
- Fundamentals: Again, they're solid. Even if the economy continues to sputter, we don't anticipate a meaningful uptick in defaults.
- Incremental Yield: As shown below, yields for loans are comparable to the overall high yield market and superior to those of other fixed income asset classes and Treasuries.
- Less Duration Risk: Since loan coupons periodically reset, they have less duration risk than most fixed income assets and can actually benefit from a rising rate environment.
Bank Loans Offer Attractive Yield Potential with Limited Duration
Source: Neuberger Berman, Bloomberg, Barclays as of April 30, 2014. Bank Loan: S&P/LSTA Leveraged Loan Index, High Yield Bond: Barclays U.S. High Yield 2% Issuer Cap Index, U.S. IG: Barclays U.S. Corporate Index, U.S. Treasury: Barclays U.S. Treasury Index, U.S. Stocks: S&P 500.
Of course, as with any non-investment grade asset class, there are risks to consider. Volatility triggered by geopolitical events and other non-fundamental driven factors could drag down the market. And more aggressive loan provisions could make certain securities more susceptible to a sell-off. Still, net new issuance (excluding refinancing) remains robust and, in our view, there's no shortage of attractive loans coming to market. So we view the recent soft demand from U.S. retail investors to be a buying opportunity for an asset class that offers attractive relative value. Many sophisticated investors appear to agree, as demand from institutions has more than offset the redemptions from retail investors over the past eight weeks.
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