Floating Rate Update
Despite a poor performance in May, we view the ﬂoating-rate loan asset class—the shining star within corporate credit so far this year—as appealing, providing potential for price appreciation, as well as a compelling yield profile.Download PDF
Year to Date
As we approach mid-year, the floating rate loan asset class has been the shining star within corporate credit in 2022 so far, supported by robust retail inflows and strong fundamentals. The asset class held strong for the first 4 months of the year (excluding a short stint in March that fully recovered in short order) having offered investors a hedge from rising rates and an attractive yield profile. In May, the asset class finally experienced weakening. We viewed the causes of this weakening to be more ancillary effects of sympathetic selling by investors, capital raises to meet cash needs, and some repositioning further out on the risk spectrum. To frame May’s historically poor return, May would rank as the third worst monthly return since December 2008 and the ninth worst monthly return since 2000. As a result of the selloff in May, the average price of the index resides slightly below $95 (versus above $98 to start 2022) with yields above 6%.
The comments below address our view on the macro landscape, fundamental and technical support of the asset, and relative value of loans.
We continue to believe the Fed will move forward with an increase in rates over the coming months. While no one is certain of when the Fed will stop raising rates, we feel comfortable with the assumption the Fed will move at least 100bps higher this year. Taking into consideration the forward guidance and Fed speak, it appears the preference remains to go hard and fast up front in the cycle and reassess toward the end of the year. The Fed must walk a delicate tightrope between fighting sustained inflation and not pushing the economy into a full-blown recession. We believe inflation prints (lagging CPI) feel “peakish” with the caveat that prices likely will remain broadly elevated across sectors for some time to come. This created additional pressure on growth projections (Atlanta Fed GDP tracker now calling for 2Q22 GDP print of 1.3% down from 1.8%). We are convinced that slowing growth is indeed real, but it is NOT our base case for a recession in 2022. While consumers are feeling pressure via price increases at the pump and in stores, we expect demand to be resilient as long as the employment environment holds. The Russia/Ukraine crisis remains challenging and tragic, but is unfortunately likely to continue. Its effects will continue to play havoc on energy, gas, commodities, potash, and other exports and countries reliant upon this centralized region’s exports. Overseas in Asia, things appeared to be opening up in China from its recent zero-COVID policy shutdown and as they worked through processing the enormous backlog of inventory while having maintained a healthy environment. As China opens, we would expect stress on supply chains to loosen, which is disinflationary in nature.
Floating Rate Fundamentals
Corporate health remains strong with many companies possessing a better balance sheet position than at year end 2019. That said, some corporations felt the impact of increased costs that eroded their (in many cases record setting) profit margins. However, many companies have figured out how to better manage their balance sheets and prioritize streamlining their business to reduce overhead, expenditures, and overall costs. Many corporations tapped the liquidity markets in summer of 2020 to shore up balance sheets and then again in summer 2021 to refinance and extend maturity walls so that quickly approaching debt is not a concern. Additionally, many companies hedge a percentage of their rate exposure to limit the impact of increasing financing rates. While companies may have seen margin compression, we still believe demand is holding strong in most cases. We do not see a swath of default activity picking up to lead to a massive wave of defaults over the next 12 months. According to the S&P LSTA, the default rate currently resides sub 50bps and the 15yr average default rate for loans is ~3%. There may be some increase over the next 12 months in default activity, but it is likely to remain well below historical averages.
Floating Rate Technicals
The asset class is largely supported by CLOs (approx. 2/3 of the buyer base). Per JP Morgan, CLO origination was resilient at $13.5bn in May which has year-to-date activity totaling $63bn year-to-date, down less than 10% yoy ($64.6bn YTD21). 2021 was a record year in CLO origination. For additional context, we broadly assume CLO origination in a calendar year in excess of $100bn as being healthy. If we annualize the CLO run rate thus far, it will handily exceed $100bn. Additionally, the retail buyer base is about 10-15% of the asset class support. While loan funds saw some modest outflows, loan funds YTD have seen inflows totaling +$21.7bn (+$1.3bn ETF) which follow +$46.5bn of inflows in 2021. Reference rates continue to move higher with the Fed hiking regardless of using LIBOR or SOFR – which given the floating rate nature of the asset class is a positive support.
Floating Rate Relative Value
While the loan asset class sold off in May, we attributed this largely to a few main drivers: sympathetic pressure to other asset classes as loans had not really gotten “hit” prior to the month of May; investors selling to meet liquidity needs (selling their best performing asset class vs the S&P 500 ETF that is approximately -15% YTD); and investors selling to move into more risk-based assets. This has resulted in a drop in the average price of the loan index to now approx. $94-95. The loan asset class is asymmetric (meaning it is capped at par). We believe there may now be a potential for not only a yield opportunity, but also the ability for price to move higher.
We believe our differentiation is our focus on selective investing in larger companies and mitigating downside risk. We focus on investing in larger issue/facility sizes with no exposure to middle-market or mezzanine type issuers. Our process screens out issuers that are less than $300m in facility size or $100m in EBITDA and we do not invest in non-USD securities. We remain highly selective in our portfolio construction (approx. 80-150 issuers) and we focus on holding meaningful positions in companies with a fundamental catalyst for outperformance. Lastly, our investment process has led to strong historical performance and downside risk protection relative to peers, as measured by downside market capture, default rates, standard deviation, and performance during 2008, 2015, and 1Q 2020. We expect to perform well if there are further episodic times of volatility and believe our process is time tested. We remain in favor of the asset class and potential benefits it offers.
For Financial Professionals Only — Not For Public Distribution
Pacific Asset Management LLC is the sub-adviser for the Pacific Funds Fixed Income Funds. The views in this commentary are as of June 20, 2022 and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Any performance data quoted represents past performance which does not guarantee future results. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed.
Past performance does not guarantee future results. All investing involves risks including the possible loss of the principal amount invested.
Pacific Life Insurance Company is the administrator for Pacific Funds. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products.
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