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Peter Higgins, BlueBay Asset Management

Beating rising rates

Peter Higgins, Partner and Senior Portfolio Manager of the BlueBay High Income Loan fund, highlights why now is a good time to protect against rising rates, and outlines BlueBay’s views on how the loans asset class is set to perform in the current macro-economic environment…

Since the global financial crisis we have been in a period of unprecedented low interest rates. However, fixed income markets were poorly prepared for US Federal Reserve (Fed) Chairman, Ben Bernanke’s, late-May announcement that the Fed  could start tapering quantitative easing. Yields on 10-year US Treasuries rose 115 basis points (bps) from May to August and both high yield (-2.17%) and investment grade (-5.2%) bonds generated negative returns. Although the Fed decided not to taper at its September meeting, we believe that we are returning to an environment of rising interest rates and that this will be the single biggest near-term challenge for fixed income investors. There is still an attractive entry point for investors into the loan asset class. A global approach is required to maximise returns, as there are significant opportunities in Europe.
US loan funds have recorded 67 weeks of consecutive inflows. Year-to-date inflows (as of September 2013) have risen to a record USD52.3bn. This is already 4.2x the total USD12.4bn of inflows in 2012 and 2.9x the previous annual record of USD17.9bn in 20104. However, despite the recent strong performance and investor inflows, we believe loans still offer an attractive risk-reward profile. According to our model, loans are not overpriced. We estimate that fair value spreads for loans, based on conservative default and recovery assumptions, are 388 basis points. Investors can therefore gain comfort that loans are cheap to fair value given that spreads are currently 462 basis points.
Since 2006, high yield bonds have traded at yields 103 basis points above loans. The yield differential between bonds and loans is currently only 83 basis points. Investors therefore have the opportunity to move up the capital structure into a more secure asset class and gain protection from rising interest rates for a relatively small give up in yield. Loans on average trade below par and at a lower price than high yield bonds.
The European secondary market is experiencing a technical tailwind. This is because limited primary issuance is forcing investors to recycle cash flows into the secondary market, supporting prices. The European market in general is less efficient than the US and we believe that there are attractive single-name situations. In both the US and Europe there are opportunities to buy loans below par ahead of potential re-financings. This enhances the internal rate of return (IRR) of the investment when those securities are refinanced at par.
US and European primary markets are attractive, but for different reasons. The US loan market benefits from a strong technical backdrop due to a heavy CLO calendar and inflows into the more deeply developed US retail mutual fund market. Fundamentally sound credits are issued with Libor floors of ~100bps, margins of ~400bps and pricing slightly below par to deliver all-in yields of ~4.75- 5.25%. Strong demand has however made it easy to borrow money and fundamental research has become increasingly important in distinguishing attractive opportunities from those loans that are being priced too tight.
The European market has a weaker technical backdrop due to restrictive legislation on CLOs and slower adoption of the loan asset class by institutional investors. As a result, the European primary market is still a buyers’ market. Pricing is more attractive, with wider margins of ~500bps and greater original issue discounts (OIDs) to deliver all-in yields of ~5.5-6%. Structures are tighter and dominated by maintenance covenants.
A key challenge with loans is that pricing is quite formulaic and heavily dependent on ratings. Investors are therefore not always adequately compensated for the risks they are taking. Conversely, very attractive loans may be cheaply priced. Investors should therefore invest with conviction in those loans that they fundamentally believe will be able to continue to pay interest and ultimately redeem at par. The need to avoid bankruptcies also means that it is not always possible to manage risk in loan portfolios simply by diversifying across sectors and geographies.
Investors have a number of options to gain access to the loan asset class. In our view, not all of these options satisfy the key success factors above. Exchange traded funds (ETFs) use limited credit selection and need to maintain high cash balances to satisfy a share creation and redemption process where loans settle physically. CLOs and the more passive style loan funds, typical of former CLO managers, utilise marginal credit selection and tend to place an over reliance on sector and geographic diversity to minimise the impact of defaults on the portfolio. We believe that active management of loan portfolios based on bottom-up, fundamental credit selection to choose loans that are appropriately priced and that will not default is the best way to invest in the asset class.
In our view, the case for investing in loans in the current market environment appears compelling. Floating interest rates mean that loans outperform in rising rate environments and we believe that we will return to such an environment once the Fed commences tapering of quantitative easing. Loans have performed well year to date, but are still attractive based on fair value and relative value to high yield bonds. While investors have a number of options for investing in loans, in our view only active management satisfies the three key success factors; price risk correctly, avoid losses and invest with conviction.

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