Senior loans: The upside of mean reversion
Market Insights: July 11,
Jeff Sujitno, CPA, CIM
Vice President and Portfolio Manager
- In times of uncertainty, senior loans have experienced price declines, but due to their structure have historically recovered through mean reversion
- 2016 has already seen a rebound in senior loan prices closer toward historical averages, with the potential for additional price gains depending on economic outcomes and the supply/demand equation
- For many investors, senior loans can be considered a core holding in the fixed-income portion of a portfolio, but investing successfully in this category requires expert knowledge and an active approach
1. Mean reversion: What it is and why it benefits the senior loan market
Generally, senior loans are fairly stable in terms of price. As a result of their seniority in the capital structure – since they’re backed by secured assets (collateral) – and their relatively short duration, senior loans have, on average, historically only traded at a marginal discount to par. When they trade near par, their capital appreciation potential is minimal. Why? Even though loan prices should theoretically rise if interest rates fall, most senior loans have embedded call provisions, meaning they are likely to be called back (or repaid) by the borrowing institution so the borrower can reissue debt under more
But let’s consider a scenario in which the prices of senior loans are depressed, as they have been since mid-2014 until recently commencing a recovery. Since mid-2014 and into the first two months of 2016, senior loans were trading well below their historical averages. During this time, the average loan price declined by 9.8% (Credit Suisse). Outside of 2008, this period represented one of the worst price drops the asset class has seen. This depressed price level was the result of heightened market uncertainty, the spreading of contagion from the high-yield market and retail outflows based on anticipation by investors that interest rate increases by the U.S. Federal Reserve Board (“Fed”) will be modest and infrequent relative to initial expectations.
At the end of February 2016, the average loan price was
To understand the upside of depressed prices on senior loans, let’s consider this price disconnect through the concept of mean reversion which states that the price of a security – in this
Since 1992, there have been four periods of price decreases, varying in length and severity (See Figure 1). Coupled with those four decreases were price increases – or mean reversion – that occurred when the prices of senior loans returned to their long-term average.
Figure 1: Senior Loan Prices
Figure 1: Senior Loan Prices (Continued)
|Period||Price Change||Date||Impact Change in price||Return from Income||Total Return|
|1||Decrease||08/98-10/02 (51 months)||-19.60%||30.60%||11.00%|
|2||Increase||11/02-01/04 (15 months)||9.90%||6.00%||15.90%|
|3||Decrease||11/02-01/04 (15 months)||-37.40%||7.70%||-29.70%|
|4||Increase||01/09-04/11 (28 months)||48.40%||16.10%||55.50%|
|5||Decrease||05/11-09/11 (5 months)||-5.80%||1.80%||-4.00%|
|6||Increase||10/11-09/12 (12 months)||5.40%||5.30%||10.70%|
|7||Decrease||07/14-02/16 (20 months)||-9.80%||7.50%||-2.30%|
|8||Increase||03/16 - current (3+ months)||3.41%||1.74%||5.15%|
|Source: Bloomberg and Credit Suisse, June 27, 2016. Total return refers to cumulative return for the period.|
From the end of February until June 27th the price of loans increased to 92.51. This represents price appreciation of approximately 3.41%. This price appreciation was mean reversion in action, as fears during the earlier part of the year subsided and loans started to move back toward their historical trading average. That coupled with a 1.74% return from income resulted in a three-month total return for the index at just over 5%. That is a fairly rapid rise that benefitted those invested in the senior loan market.
2. Assessing today’s environment to determine the likelihood of continued mean reversion
So, the big question for investors now is whether the senior loan market is poised to continue its move back to its long-term average? There are two primary areas to examine to help gauge whether the senior loan market might be poised for further mean reversion: implied default rates and institutional demand.
Table 1 shows the implied default rate of the Credit Suisse Senior Loan Index.
|As at June 27, 2016||Price Increase|
|Hurdle rate¹ (bps)||250||B|
|Adjusted spread (bps)||345||C=A-B|
|Historical recovery rate²||68%||D|
|Implied default rate||10.78%||E=C/(1-D)|
Source: Credit Suisse, JP Morgan, Moody’s. Loan Index refers to the Credit Suisse Leveraged Loan Index.
3. Loans should be a core holding, but you need to remain active
Although senior loan prices remain below average, market indicators remain mixed on when there will be
We believe senior loans should continue to be a core holding
Table 2: Hypothetical Return Scenarios
|Price Falls||Price Stays Flat||Price Rises|
|Loan price at year end ($)||89||93||97|
|Price change ($)||-4||0||4|
|Index yield at June 27/2016||6.62%||6.62%||6.62%|
|LIBOR in excess of 100 bps floor||0||0||0|
|Illustrative total return||1.12%||5.42%||9.72%|
Source: Calculations are illustrative based on index data from Credit Suisse, as at June 27, 2016.
Going forward, whether mean reversion continues, we believe that senior loans, especially at their current price point, should be considered a core holding that offers an attractive risk/return profile. With a recent yield of 6.62%, while exhibiting a low duration profile, senior loans provide an attractive coupon for investors as they wait for potential price appreciation. In our view, as investors accept that we are in the later stages of the credit cycle and risk-off conditions may hold or gain momentum, they should begin to move up the capital structure into senior loans, increasing demand and pushing loan prices higher. We believe that you need to be an active, nimble and highly experienced manager to move effectively between names and sectors in the challenging loans market. Investors who possess the expertise and take an active approach to senior loans can uncover and exploit the relative value opportunities that arise. It’s an approach we strive to deploy in actively managing the IA Clarington Floating Rate Income Fund and IA Clarington U.S. Dollar Floating Rate Income Fund.
For more information about IA Clarington Floating Rate Income Fund and IA Clarington U.S. Dollar Floating Rate Income Fund, contact your IA Clarington sales team.
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