Pacific Asset Management, November 2018
Bank loan portfolio managers JP Leasure and Michael Marzouk discuss the loan market, outlook, and portfolio strategy until the end of 2018.
Provide an update on the current market environment.
Marzouk: At a high level, the economy and corporate fundamentals are positives for risk assets. Strong corporate earnings, tax reform, high levels of consumer confidence, and low unemployment have helped fuel robust U.S. gross domestic product (GDP), which was 4.2% in the second quarter of 2018. These are being partially offset by rising interest rates as a result of a less accommodative Federal Reserve, inflation fears, and tariff tensions.
In the near-term, we believe the strong corporate health and low default environment will continue, which are positives for credit assets. Longer-term, we are certainly mindful of the potential effects from rising rates, harmful geopolitical factors, supply-chain disruptions resulting from tariffs, or increasing inflation as negatives for risk assets and the economy. We are also cognizant of asset valuations and total leverage, which have generally increased.
Table 1: Limited places to hide in October
|Index Total Return
||YTD Returns (%)
|EM USD Aggregate||-1.37||-3.62|
Sources: Bloomberg Barclays and Credit Suisse as of October 31, 2018.
A strong fundamental and technical backdrop for bank loans is helping navigate interest-rate and risk volatility.
Thus far in 2018, bank loan prices have held steady, especially when compared to investment grade and high yield.
Sources: Bloomberg Barclays and Credit Suisse as of October 31, 2018 (31-Dec = 1).
With LIBOR moving higher at an accelerated pace, floating-rate instruments are best positioned to buffer further increases in rates.
Source: Federal Reserve as of September 30, 2018.
What has been the performance of bank loans in 2018?
Leasure: As expected, loans have been a stable and a defensive asset class in 2018. The asset class has experienced a coupon-like return thus far, returning 4.36%, outperforming both the Bloomberg Barclays U.S. Aggregate Bond Index and the Bloomberg Barclays U.S. Corporate High Yield Index returning –2.38% and 0.93%, respectively. Additionally, while investment grade and high yield have seen multiple months of
negative returns through October, loans have not had a month of negative total returns, providing a relatively stable return profile. The asset class is certainly benefiting from a continual rise in London Interbank Offered Rate (LIBOR) (above), collateralized loan obligation (CLO) issuance (Chart 2), and retail demand (Chart 3).
From a more granular level, the strongest performance has been in sectors where increasing commodity prices and robust consumer sentiment benefit issuers the most, such as Metals & Mining, Energy, and Retail. Distressed loans (those trading below $90 price) have substantially outperformed the performing segment of the loan market. Similarly, lower credit quality loans have outperformed their higher credit quality counterparts. We believe maintaining a pulse on the performance of the distressed segment of the market is an important indicator of risk appetite within credit markets (Chart 1).
Chart 1: Loans priced below $90 remain an important indicator of the market's propensity toward risk
Sources: Credit Suisse and Federal Reserve as of September 30, 2018.
Discuss the technical support within the bank loan market.
Marzouk: The technical environment remains quite healthy for both net issuance and demand. Compared to 2017, gross new issuance is down, but this is due in large part to a slowdown in refinancing/repricing activity. Net issuance remains consistent with the past few years (Chart 4). On the demand side, floating-rate fund flows have been robust given rising short-term rates (page 1) and attractive yield levels. CLO issuance also has been strong with year-to-date issuance of $111 billion (Chart 2), after 2017’s total CLO issuance of
$124 billion. It is expected that CLO issuance for 2018 will exceed that of 2017.
Chart 2: CLO issuance has been robust and is expected to exceed levels reached in 2017
Source: J.P. Morgan as of September 2018
Chart 3: Retail demand for the bank loan asset class remains supportive given the further tightening of monetary policy
Source: J.P. Morgan as of September 30, 2018
Chart 4: Gross loan issuance has been very strong; however, due to refinancing/repricing activity, net loan issuance has been lower and relatively stable over the last several years
Source: J.P. Morgan as of September 30, 2018.
Can you address the shift in the bank loan market to where there is now a greater amount of loans without convenants (cov-lite) than those with covenants (cov-heavy)?
Leasure: By way of definition, cov-lite loans are those that generally include only incurrence-based covenants (those that must be met for an issuer to borrow additional money) versus a maintenance-based covenant (which is required to be met at all times). Cov-lite loans are less restrictive for the borrower than cov-heavy loans. The U.S. market has shifted over the last decade to where nearly 75% of the market reflects cov-lite loans, with 25% of the market regarded as cov-heavy (Chart 5).
The real surprise in this is that cov-heavy loans generally have higher spreads than cov-lite, suggesting cov-heavy may actually be more risky. Empirically, from 2013–2016, default rates were higher for cov-heavy loans than for cov-lite loans, although this has shifted over the last 12 months. We believe this cov-lite dominant market is not changing anytime soon, so sound credit underwriting and truly “knowing what you
own” is more vital today.
Chart 5: The market shift from cov-heavy loans to cov-lite has been increasing and is likely here to stay
Source: Credit Suisse as of September 30, 2018.
Provide an update on leverage levels within bank loans and your outlook of the loan default environment.
Marzouk: Recently, we have witnessed an increase in overall leverage in loans coming to market. Previously, total leverage (loan debt/EBITDA) was approximately 5-6x; however, recently, we have experienced some loans coming to market with 7x leverage along with aggressive pro-forma adjustments being made to EBITDA (Chart 6). We continue to monitor this uptick in leverage and believe this will certainly play a factor in the next downturn. However, at this time, we have not seen this increase in leverage translate to higher loan-default rates. Current estimated loan-default rates reside near 2% (Chart 7), which is below the historical average. The likelihood of continued low defaults is high based on current economic prospects, reduced regulation, and current fiscal stimulus.
Chart 6: Merger and acquisition loans by unadjusted leverage range
Source: LCD, an offering of S&P Global Market Intelligence, as of September 2018. Based on issuers with EBITDA of $50 million or greater.
Chart 7: After the tick up in 2015, default rates are now back to multi-year lows
Source: J.P. Morgan as of September 30, 2018.
What do you see as some of the greatest benefits bank loans offer in this environment?
Leasure: In my opinion, loans offer a relatively attractive yield in a defensive asset class. With the increase in LIBOR over the past few years, the four-year effective yield on the Credit Suisse Leveraged Loan Index (as of 9/28/18) is now 6.14% versus the Bloomberg Barclays U.S. Corporate High Yield Index yield to worst of 6.24% (Chart 8). Given the coupon also “floats,” the limited duration (assume 0.25 years) provides a significant cushion against rising interest rates. Lastly, loans also exhibit a low correlation to most fixed-income asset classes, especially interest-rate sensitive investments. Additionally, per J. P. Morgan, over the past 15 years, loans have had a negative correlation to Treasury bonds (Table 2).
Table 2: Bank loans have been historically negatively correlated with Treasuries
|Correlation to Bank Loans
|JPM High Grade Index||0.27|
|JPM High Yield Index
Source: J.P. Morgan as of December 31, 2017.
Chart 8: Yields of high yield and bank loans have compressed, resulting in comparable yields between the asset classes
Sources: Bloomberg Barclays and Credit Suisse as of September 30, 2018.
Discuss current portfolio positioning.
Marzouk: Entering 2018, we were underweight yield relative to the benchmark. Our underweight was primarily the result of limited exposure to distressed or defaulted issuers. Given our focus on the performing segment of the loan market, we expect to maintain our yield underweight. Within the bank loan asset class, we remain cognizant of increasing leverage and tightening valuations; however, we maintain a favorable view on both the fundamental and technical aspects of the market. Given this, we continue to emphasize loan selectivity and robust credit underwriting.
We are overweight in the Packaging, Food/Tobacco, and Manufacturing sectors. We prefer to emphasize sectors that derive most of their earnings from the domestic market. We are underweight in the Healthcare, Service, and Energy sectors. Lastly, due to our investment process and current positioning, we would welcome a return of sustained volatility as we believe our portfolio is well positioned amidst a backdrop of market instability.
What is your outlook for the remainder of 2018?
Leasure: Thus far in 2018, bank loans have been largely immune to macroeconomic volatility. Although new-issue credit metrics have become incrementally more aggressive, we maintain our constructive outlook for bank loans. We also expect the positive technical to remain for floating-rate loans from healthy CLO origination, demand for assets that benefit from rising LIBOR, and historically wide loan spreads. This should continue a relatively stable environment for the asset class through the remainder of 2018, especially when compared to more interest rate sensitive instruments. We believe bank loans still provide compelling risk-adjusted value.
Beyond 2018, valuations and more aggressive underwriting could result in weakness if the economy were to slow. However, with investment selectivity and active management as the hallmarks of our investment style, we will continue to adjust the portfolio as market, economic, and valuation dynamics change.
Aggregate is represented by the Bloomberg Barclays U.S. Aggregate Bond Index, which is composed of investment-grade U.S. government bonds, investment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment-grade bonds.
Bank Loan is represented by the Credit Suisse Leveraged Loan Index, which is designed to mirror the investable universe of the U.S. dollar-denominated leveraged-loan market.
Corporate is represented by the Bloomberg Barclays U.S. Corporate Index, which includes publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be registered with the Securities and Exchange Commission (SEC).
EBITDA, or Earnings Before Interest, Tax, Depreciation, and Amortization, is a measure of a company’s profits before any of these net deductions are made.
EM USD Aggregate is represented by the Bloomberg Barclays Emerging Markets USD Aggregate Index which is composed of fixed and floating-rate U.S. dollar-denominated debt issued from sovereign, quasi-sovereign, and corporate emerging-market issuers.
High Yield is represented by the Bloomberg Barclays U.S. Corporate High Yield Index, which represents the U.S. dollar-denominated, high-yield, fixed-rate corporate bond market.
J.P. Morgan High Grade Index is represented by the J.P. Morgan U.S, Liquid Index (JULI), which measures the performance of the most liquid securities in the investment-grade corporate-bond market.
J.P. Morgan High Yield Index is represented by the J.P. Morgan Domestic High Yield Index is designed to mirror the investable universe of the U.S. dollar-denominated high-yield corporate-debt market.
LIBOR, or London Interbank Offered Rate, is the benchmark interest rate that banks charge each other for loans.
The S&P 500® index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S. stock market.
Treasury is represented by the Bloomberg Barclays U.S. Treasury Index, which is composed of U.S. dollar denominated, fixed-rate, nominal debt issued by the U.S. Treasury.
Yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting.
About Pacific Asset Management
Founded in 2007, Pacific Asset Management specializes in credit-oriented fixed-income strategies. Pacific Asset Management is a division of Pacific Life Fund Advisors LLC, an SEC-registered investment adviser. As of September 30, 2018, Pacific Asset Management managed approximately $10.6 billion. Assets managed by Pacific Asset Management include assets managed at Pacific Life by the investment professionals of Pacific Asset Management.
Important Notes and Disclosures
All investing involves risks including the possible loss of the principal amount invested. Debt securities with longer durations or fixed interest rates tend to be more sensitive to changes in interest rates, making them generally more volatile than debt securities with shorter durations or floating or adjustable interest rates. The Pacific Funds Fixed-Income Funds are subject to liquidity risk (the risk that an investment may be difficult to purchase and sell within a reasonable amount of time at approximately the price the Fund has
valued the investment) and credit risk (the risk an issuer may be unable or unwilling to meet its financial obligations, risking default).
Floating-rate loans (usually rated below investment grade) and high-yield/high-risk bonds (“junk bonds”) have greater risk of default than higher-rated securities/higher-quality bonds that may have a lower yield. Interest rates and bond prices have an inverse relationship. The Funds are also subject to foreign-markets risk.
This commentary represents the views of the portfolio managers at Pacific Asset Management as of 11/1/18, and are presented for informational purposes only. These views represent the opinions of the portfolio managers and should not be construed as investment advice, an endorsement of any security, mutual fund, sector, or index, or to predict performance of any investment. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Sector names in this commentary are provided by the Funds’ portfolio managers and could be different if provided by a third party.
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