Senior loans: The upside of mean reversion

Market Insights: July 11, 2016 • IA Clarington Investments Active Insights

Jeff Sujitno, CPA, CIM
Vice President and Portfolio Manager

 

Summary

  1. In times of uncertainty, senior loans have experienced price declines, but due to their structure have historically recovered through mean reversion
  2. 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
  3. 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 favourable terms.

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 approximately US$89.50, as per the Credit Suisse Leveraged Loan Index, compared to the five-year average of US$95.80.

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 case a loan – will eventually revert to its long-term average. The argument for anticipated mean reversion is even stronger for senior loans as the loans mature at par as opposed to other securities like common equities which do not have a set par value. However, there have been periods of disconnect, as in 2015-2016, associated with price volatility. When loan prices fall amid negative economic pressure, there is a chance that these prices will rebound for the same reasons that they trade around par under typical conditions.

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

LineGraphEng

 

 

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.

Implied default rates. With a recent senior loan spread of 595 basis points over U.S. Treasuries, the market has been pricing in an implied default rate of ~11% (see table 1). This spread is far higher than the long-term average of senior loan defaults of 3.3% and not much lower than 2009, when defaults spiked to 12.8%. Similar to high-yield bonds, the greatest risk to senior loans is a U.S. recession, which typically impedes the ability of businesses to repay their loans. Indicators that our team uses to assess whether we are moving into a recessionary environment include electrical demand, housing and mortgage data, sales of automobile and durable goods, data from the Institute for Supply Management’s Manufacturing Index and the Purchasing Managers’ Index, job creation, consumer sentiment, retail sales, spreads, the Fed Funds rate and futures, etc. With these and other indicators in mind, we currently do not foresee a recession. This suggests to us that the market has been oversold and prices should continue to revert to the mean.

 

Table 1 shows the implied default rate of the Credit Suisse Senior Loan Index.

As at June 27, 2016 Price Increase
Spread (bps) 595 A
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. ¹ Hurdle rate is an internal estimation of approximate historical spread during periods of minimal defaults. ² Per JP Morgan.

 

Institutional demand. Another indicator of a healthy senior loan market is institutional demand. Flows in the senior loan market are mainly driven by institutions such as pensions, insurance companies and endowments, while the high-yield market is mainly driven by retail investors and exchange-traded funds. Institutional demand for senior loans has eased from record levels in 2014 and 2015. Reasons for this slowdown include higher financial market volatility, Fed uncertainty about where the U.S. economy is headed (and how quickly), and markets that are pricing in the possibility of a U.S. recession. Analysts have reduced their 2016 institutional demand forecast (via CLO issuance) to a range between US$40 and US$70 billion, compared to US$110 billion in 2015 (the second highest in history) . Through the end of May year-to-date outflows from U.S. retail investors have been US$6 billion, compared to US$19.6 billion of institutional inflows. History suggests that supply ultimately recalibrates to the level of demand, but that this process takes time.


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 full mean reversion. So, what does this mean for the senior loan market over the next 12 months?

We believe senior loans should continue to be a core holding within a portfolio. This is typically a coupon clipping asset class and it is rare to encounter a situation, like we see now, where loan prices are depressed to this extent. In our base case scenario, where loan prices remain at US$93 (on average), yields are about 6.62% and the default rate sits at 1.2%, the Index could generate a return of 5% to 5.5% (see Table 2) over the next 12 months, vs. the average annual return of the asset class of 4.3% over the last 5-years. If further mean reversion occurs this year and prices rebound to their historical averages of close to US$96, a 12-month return for the Index could climb to almost double digits. However, if loan prices were to sink lower, say to US$89, coupon income would erode and the Index could still see a positive return of 1.12% over the next 12 months.

 

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
Default loss -1.20% -1.20% -1.20%
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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