Pacific asset management, June 2016
Commentary from Pacific Asset Management, the manager of Pacific FundsSM Fixed-Income Funds.
Bank loan portfolio managers, JP Leasure, and Michael Marzouk, discuss the loan market environment and their outlook for 2016.
Start at the top. Describe the market environment in 2016.
Leasure: The past three months have seen an impressive rally in credit risk assets. Since yields peaked on February 11, 2016, higher commodity prices, stabilized economic data, and dovish central bank action have fueled a strong market environment for risk assets (Table 1). Too much pessimism was priced into growth expectations and the market has adjusted quickly from the early 2016 sell-off. Over the past few weeks, we
have seen risk assets produce more muted returns as ongoing macro and microeconomic concerns remain. We believe these concerns may lead to further bouts of volatility, and thus, elevated credit risk premiums in the latter half of 2016.
Table 1: An impressive rally in credit risk assets
|Index Returns (%)||Since 2/11||Year-to-Date||1-Year|
|High Yield (HY)||13.94||8.06||–0.81|
|Source: Barclays, Credit Suisse, as of May 31, 2016.|
How have bank loans performed during this period of volatility?
Marzouk: We experienced a lower volatility profile for bank loans. The asset class was insulated in many ways from factors that drove the weakness in high yield: lower commodity exposure (4% vs. 18%), better technicals, and less sensitivity to equity and interest-rate volatility.
Within the bank loan asset class, the recent rally has been primarily focused on the distressed issuers (loans below $90 price). This includes most of the commodity issuers and many large and leveraged companies having a high correlation with risk appetite (Chart 1).
How would you assess the economic outlook?
Marzouk: Our base case continues to be an expectation of low global growth. We do not view a U.S. recession as likely in 2016, given the recent improvement in U.S. economic data, notably manufacturing (Chart 2). The International Monetary Fund (IMF) currently forecasts a 3.2% global gross domestic
product (GDP) in 2016, the lowest since 2008. Concern around emerging-markets growth, a strong driver of capital expenditures over the past few years, is putting downward pressure on inflation and earnings outlooks. The reality is that we are in a slow growth, low-inflation environment that is prone to macroeconomic shocks, thus constraining final demand.
Chart 1: Bank loan market volatility has been focused on distressed and commodity-related issuers
Source: Credit Suisse, as of May 31, 2016
Chart 2: The recent stabilization in economic data has been supportive of the return of risk appetite
Source: St. Louis Federal Reserve, as of June 1, 2016
What’s next for the Federal Reserve (Fed)?
Leasure: The Fed is in a difficult position to raise the federal funds rate materially. Global growth and inflation are underwhelming, and foreign central banks are becoming more aggressive, notably the Bank of Japan (BOJ) and European Central Bank (ECB). While the Fed is signaling two rate hikes before year-end, there are challenges to accomplishing this current goal.
What about corporate fundamentals?
Leasure: Corporate fundamentals have been in decline during the past year due to profit weakness and a lack of top-line growth. The decline in profits is not just a single commodity, China, or manufacturing story, as we have seen broad declines across various sectors. Higher cost operators and more leveraged balance sheets are not well positioned for a ‘reversion to the mean’ of earnings with the current GDP growth expectation.
We would expect bank loan defaults in this market environment to move toward more historical ranges of 3–4%, yet continue to remain low. Excluding commodity sectors, we do not believe a surge in defaults is likely, given the slow but positive growth environment along with open capital markets providing refinancing opportunities.
Marzouk: We have seen the bank loan market split, as it typically does later in the cycle, into performing and distressed loans (Chart 3). Companies with solid balance sheets, stable free-cash flow, and meaningful asset coverage have performed well, trading around par. On the other hand, companies that have missed earnings, seen leverage increase, or warned on the profit outlook have seen sharp deterioration in prices.
Chart 3: The distressed part of the loan market has grown, given the weakness in corporate profit outlooks
Source: Credit Suisse, as of May 31, 2016
Describe the technical environment.
Marzouk: Bank-loan technicals have been balanced year-to-date, with weakness in demand offset by limited
net new issuance. Year-to-date, CLO issuance has been weak, with the upcoming Dodd-Frank risk retention rule’s constraining origination (Chart 4). Thus far, only $21 billion of CLOs have been issued in 2016 versus $55 billion during the same time period last year.
Chart 4: CLO issuance has been constrained due to upcoming risk retention rules going into effect in December 2016
Source: JP Morgan, as of June 3, 2016
The second part of the demand equation has been floating-rate fund flows. Mutual funds reached a peak of about 22% of the total asset class in 2013. Since then, we have seen steady outflows, unwinding most of what came into the asset class from 2013 (Chart 5). Year-to-date, fund outflows are a negative $6 billion. Recently, weekly fund flows have oscillated between positive and negative as investors have looked at
the asset class on a relative value basis. We believe the headwinds of significant outflows are largely behind us.
Chart 5: Floating-rate fund flows have largely reversed the record-setting inflow of 2013
Source: JP Morgan, as of June 3, 2016
Table 2: Bank Loan technicals have been balanced in 2016
|Net New Issuance ($B)||27||64||169||188||87||14|
|Retail Inflows ($B)||14||12||63||–24||–22||–6|
|CLO Issuance ($B)||14||56||87||132||110||21|
|Total Demand ($B)||28||68||150||108||88||15|
|Supply Surplus/ (Shortfall) ($B)||–0.3||–4.4||18.7||80.1||–0.6||–0.2|
Source: JP Morgan, as of June 3, 2016. Net issuance adjusts for paydowns and repricing/refinancing activity.
Putting this macroeconomic, fundamental, and technical backdrop together, how do you view current valuations?
Leasure: Following the rally of the past few months, we view valuations as back to a fair value range. Four-year discount margins (DM), our preferred measure of spread, remain above historical averages. Also, yields on the asset class remain attractive at an effective yield of 5.92%. Though, if you remove distressed issuers, discount margins are around the post-crisis averages of the past six years (Chart 6). Therefore, we look at valuations as fair given the split between the distressed and performing loan markets.
Chart 6: Bank Loan yields are back to post-crisis averages
Source: Credit Suisse, as of June 2, 2016. The Credit Suisse Institutional Loan Index removes any loan with a dollar price less than $90.
Describe your portfolio strategy over the past year.
Marzouk: Our strategy has been one of caution. We have had a meaningful underweight to risk relative to our benchmark, as measured by yield. During the past year, our portfolio themes have been 1) limiting exposure to commodity-related issuers, 2) focusing on U.S.-centric earnings, and 3) investing in companies with strong balance sheets and asset coverage positioned for a slow growth environment. Our strategy is in line with our philosophy of seeking to participate to the upside while protecting capital in periods of negative market performance.
During the past two months, we have begun to increase our risk allocations. This has been driven by a few macroeconomic factors such as positive but underwhelming U.S. growth prospects, a cautious Fed, and stabilizing commodity prices. Our underweight to risk assets during the past year has also allowed us to capitalize on relative-value trading opportunities. While we remain underweight to interest rate exposure as compared to the benchmark, this is due to our limited exposure to distressed issuers and the commodity sectors.
What is your outlook for the remainder of the year?
Leasure: We expect the U.S. economy to continue to grow, although at unspectacular levels. The rally of the past few months has moved bank loans, especially performing loans, into a range we view as fair value. Therefore, we would look to more of an income or coupon-like return profile in the short term.
However, the ongoing macroeconomic concerns associated with global growth, China, central bank action, and commodity prices may lead to volatility. A bout of summer volatility would be an opportunity to once again capitalize on active management and trading opportunities. We have a high-conviction portfolio, and would look at volatility as an opportunity to add value selectively through credit risk assets.
How would you state the value proposition today?
Marzouk: It’s one of risk diversification relative to more equity-like or interest-rate sensitive strategies. The past year has shown bank loans to be a low volatility asset class that can diversify credit or duration risk. A potential return profile of 4–6% in 2016 for performing loans is in line with the historical averages of the asset class. However, adjusted for volatility, notably against high yield, bank loans may serve as a very nice
complement to other risk factors within fixed income.
Bank Loans is based on the Credit Suisse Leveraged Loan Index, which is designed to mirror the investable universe of the U.S. dollar denominated leveraged loan market.
Credit Suisse Distressed Loan Index is a sub-index, which is designed to mirror the distressed sector of the U.S. Dollar-denominated leveraged loan market.
Credit Suisse Institutional Leveraged Loan Index is a sub-index, which is designed to more closely reflect the investment criteria of institutional investors by sampling a lower volatility component of the market.
Corporate is based on the 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).
High Yield is based on the Barclays U.S. High-Yield Index, which covers the universe of fixed rate, non-investment-grade debt.
This publication is provided by Pacific Funds. These views represent the opinions of Pacific Asset Management and are presented for informational purposes only. These views should not be construed as investment advice, the offer or sale of any investment, or to predict performance of any investment. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are based on current market conditions, as of June 2015, and are subject to change without notice.
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