Bank Loans: Opportunities Are Knocking
Bank loans present a strong relative value opportunity while providing short duration, stable current income and low defaults
Looking out over the next 12 months, we expect loans to benefit from their safe spread and short duration to generate a full year return of 4-6% – a compelling prospect given the general context of low to negative global interest rates.
- On a relative value basis versus other asset classes, loans screen even more attractive given their short duration, convexity profile and senior secured spread, illustrated by Figure 1. In addition to the attractive yield, loans offer protection against both potential rising interest rates and a potential stalled recovery given the security of the asset class.
- Furthermore, investment grade is now yielding negative real yields for the first time on record, in conjunction with the longest duration in its history.
The macro environment remains generally favorable for bank loans this year, with an accommodative Federal Reserve and a high likelihood of additional fiscal stimulus. GDP is expected to grow +5%, and earnings and revenue for the S&P 500 are set to increase 23% and 8%, respectively. Against this backdrop, we believe corporate balance sheets will continue to repair themselves and default rates will trend lower.
The technical environment should remain supportive as investors begin to rotate into floating rate assets to hedge potential interest rate risk, CLO formation remains strong and global institutional investors continue to search for yield against a modest net new issue supply calendar in 2021.
We believe the Pandemic’s trajectory (vaccine efficacy/new variants/speed of rollout) will be a key driver of the macro environment and credit conditions for bank loans in 2021.We expect the market will continue differentiating between individual credit fundamentals and exacerbate dispersion given the likelihood of an uneven recovery and reopening.
Our view is that security selection will remain critical to generate alpha. Given Ares’ differentiated platform and experience, we believe we are well-equipped to navigate this environment, as demonstrated by our performance over several cycles.
Favorable Supply/Demand Technical
Demand for loans is coming from CLOs, retail investors and institutional accounts while organic new supply remains limited.
For 2021, we expect CLO issuance of approximately $100-$110 billion, which compares to $92 billion of issuance in 2020. Our view is based on additional tightening of liabilities, a decent supply pipeline that we believe will give managers sufficient collateral for new deals and an attractive carry opportunity for yield-hungry buyers relative to other securitized products with similar ratings.
Retail mutual funds have seen the largest inflows in years to start this year, and we expect flows to be net positive on the year as the market remains focused on the potential for rising rates (see Figure 2).
Institutional investors are also rotating into floating rate products as a defensive measure against rising rates and tight spreads.
We expect supply to increase only slightly from a total issuance of $311.9 billion in 2020 due to modest LBO/M&A activity thus far in 2021.
Improving Fundamentals But with Increased Dispersion
A strengthening macroeconomic scene provides a backdrop for pockets of volatility and increased dispersion within the asset class.
Loan fundamentals, which troughed in Q2 2020, began to rebound in 2H20. For 2021, we expect corporate fundamentals to continue to improve on the back of a macro rebound and related GDP growth, and a return to more normal underlying activity, supported by vaccine dissemination and continued fiscal and monetary support.
While many companies were able to access capital to manage through COVID-driven lockdowns (and keep the default rate lower than initially anticipated); we remain concerned about the continued viability of certain companies given their new debt loads. We believe this increases the possibility of ‘zombie’ credits in COVID-impacted sectors. This will be a key area to watch this year and into 2022 and underscores the importance of credit selection in a market with elevated dispersion (as shown in Figure 3). We expect the market to shift from beta to alpha opportunities in the coming year.
It is in these types of environments, where we believe credit selection is paramount and loss avoidance is the key to “winning”, that our demonstrated and disciplined investment process and extensive credit platform allow Ares to skillfully navigate this market.
Lower Default Expectations
Default expectations are benign in 2021 and beyond.
Defaults jumped from 2.1% in 2019 to a 5-year high of 4.3% in 2020. Given companies’ ability to access the capital markets throughout the Pandemic, expectations for continued fiscal stimulus and a normalization of macro activity, it is widely forecasted by market participants that the default rate has peaked and will fall to approximately 3.5% in 2021, in line with the historical average, and even lower in 2022.
- With an average price of $96.80 and an average 3-year yield of 4.84%, loans offer strong absolute risk-adjusted return opportunities and look attractive compared to other fixed income alternatives which have much longer duration. We do not expect front end rates to rise in the near term; however, we expect loans to perform well in 2021 on an absolute and relative basis compared to other fixed income asset classes and provide a hedge for investors looking to protect themselves from a rising rate environment and a steepening rate curve.
- We believe attractive opportunities abound within the loan asset class today and expect the asset class to deliver returns of 4-6% to investors in 2021. However, we expect the recovery to be uneven and anticipate an elevated level of idiosyncratic credit events looking into 2H21 and beyond.We believe a manager skilled at bottom-up credit selection, able to construct portfolios using a top-down overlay of macro factors and capable of tactically allocating a portfolio based on relative value is necessary to outperform.
Jason Duko, Portfolio Manager of U.S. Liquid Credit | Samantha Milner, Portfolio Manager of U.S. Liquid Credit | Michael Schechter, Head of Credit Trading | Ruben Valverde, Ares Quantitative Risk & Research Team | Julie Greenman, Global Liquid Credit Product Management & Investor Relations | Florina Yang, Global Liquid Credit Product Management & Investor Relations
 Source: JPM. As of November 24, 2020.
 Source: Goldman Sachs. As of February 2, 2021.
 FactSet. As of January 29, 2021.
 Note: Past performance is not indicative of future results.
 Source: JPM Morning Intelligence. As of December 31, 2020.
 Source: Credit Suisse. As of January 31, 2021.
Credit Suisse Leveraged Loan Index (“US Loans) is designed to mirror the investable universe of the $US-denominated leveraged loan market. The index inception is January 1992. The index frequency is daily, weekly and monthly. New loans are added to the index on their effective date if they qualify according to the following criteria: 1) Loan facilities must be rated “5B” or lower. That is, the highest Moody’s/S&P ratings are Baa1/BB+ or Ba1/BBB+. If unrated, the initial spread level must be Libor plus 125 basis points or higher. 2) Only fully-funded term loan facilities are included. 3) The tenor must be at least one year. 4) Issuers must be domiciled in developed countries; issuers from developing countries are excluded.
Credit Suisse Western European Leveraged Loan Index (“EU Loans”) is designed to mirror the investable universe of the leveraged loan market of issues which are denominated in US$ or Western European currencies. The issuer has assets located in or revenues derived from Western Europe, or the loan represents assets in Western Europe, such as a loan denominated in a Western European currency. Loan facilities must be rated “5B” or lower. That is, the highest Moody’s/S&P ratings are Baa1/BB+ or Ba1/BBB+. Only fully funded term loan facilities are included and the tenor must be at least one year. Minimum outstanding balance is $100 million and new loans must be priced by a third-party vendor at month-end. The index inception is January 1998.
The ICE BofA U.S. High Yield Constrained Index (“US HY”) is a market-value-weighted index of all domestic and Yankee high-yield bonds, including deferred interest bonds and payment-in-kind securities. Issues included in the index have maturities of one year or more and have a credit rating lower than BBB-/Baa3 but are not in default. The ICE BofAML U.S. High Yield Constrained Index limits any individual issuer to a maximum of 2% benchmark exposure.
The ICE BofA European Currency High Yield Constrained Index (“EU HY”) tracks the performance of EUR and GBP denominated below investment grade corporate debt publicly issued in the eurobond, sterling domestic or euro domestic markets. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of EUR 250 million or GBP 100 million. Original issue zero coupon bonds and pay-in-kind securities, including toggle notes, qualify for inclusion in the Index. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to-floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. Contingent capital securities (“cocos”) are excluded, but capital securities where conversion can be mandated by a regulatory authority, but which have no specified trigger, are included. Other hybrid capital securities, such as those issues that potentially convert into preference shares, those with both cumulative and non-cumulative coupon deferral provisions, and those with alternative coupon satisfaction mechanisms, are also included in the index. Equity-linked securities, securities in legal default and hybrid securitized corporates are excluded from the index.
The Bloomberg Barclays U.S. Corporate Bond Index (“Investment Grade”) is an unmanaged market-value-weighted index of investment-grade corporate fixed-rate debt issues with maturities of one year or more.
The BofA Merrill Lynch Constrained Duration U.S. Mortgage Backed Securities Index (“Mortgage Backed”) tracks the performance of U.S. dollar denominated 30-year, 20-year, and 15-year fixed rate residential mortgage pass-through securities publicly issued by U.S. agencies in the U.S. domestic market.
The J.P. Morgan Global Aggregate Bond Index (“Emerging Market”) consists of the JPM GABI US, a U.S. dollar denominated, investment-grade index spanning asset classes from developed to emerging markets, and the JPM GABI extends the U.S. index to also include multi-currency, investment-grade instruments. Launched in November 2008, the JPM GABI represents nine distinct asset classes: Developed Market Treasuries, Emerging Market Local Treasuries, Emerging Markets External Debt, Emerging Markets Credit, US Credit, Euro Credit, US Agencies, US MBS, Pfandbriefe – represented by well-established J.P. Morgan indices. The JPM GABI US is constructed from over 3,200 instruments issued from over 50 countries, and collectively represents US$8.6 trillion in market value. The JPM GABI is constructed from over 5,500 instruments issued from over 60 countries and denominated in over 25 currencies, collectively representing US$20 trillion in market value.
The ICE BofA U.S. Municipal Securities Index (“Municipal Bond”) tracks the performance of the investment-grade U.S. tax-exempt bond market. Qualifying bonds must have at least one year remaining term to maturity, a fixed coupon schedule, and an investment grade rating (based on average of Moody’s, S&P, and Fitch).
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