Senior loans and reinvestment risk
How active management can protect investors
“To invest in higher yielding securities, I believe you need to be selective. That requires a very robust, active approach which includes a lot of credit work to appropriately identify risks and opportunities in the market.”
Senior Vice-President, Investments iA Clarington Investments
1. The compelling case for senior loans in a rising rate environment
As we progress into 2017, it’s clear that investors should consider making senior loans a consistent core holding within their portfolio, as favourable conditions continue to help the asset class. With the strengthening global economy and the potential inflationary policies of U.S. President Donald Trump’s administration, we expect that interest rates will continue to rise, which, in turn, make the floating rate feature of senior loans highly attractive.
Rising interest rates, on the other hand, have plagued traditional fixed income. Bond yields have been rising in the U.S. and Canada for at least the past six months, creating headwinds for the interest-rate-sensitive asset class.
With interest rate sensitivity a clear challenge for fixed income, investors can instead look to senior loans for low duration in their portfolios. Senior loan coupons are reset every three months, based on a spread over a reference rate, such as the three-month London Interbank Offered Rate (LIBOR). As these reference rates rise, the coupons of the loans rise as well. Because of this resetting, senior loans are also known as “floating rate loans” and are particularly attractive in a rising interest rate environment.
Recently, the financial press correctly highlighted the benefits of adding loan exposure to fixed income portfolios. This recent appreciation for adding loan exposure has led to increased flows into the space (see Figure 1).
Figure 1:U.S. leveraged (senior) loan fund flows
Source: JPMorgan, December 31, 2016.
"In a market with robust inflows, we believe reinvestment risk needs to be actively managed to improve outcomes"
2. Be aware of reinvestment risk as demand grows and borrowers refinance
As we’ve seen, senior loans are attractive in a rising rate environment as investors seek defense in the form of a low-duration fixed income solution, as well as gaining some offense through rising coupons when interest rates rise. However, there are challenges worth considering.
In the spirit of open dialogue and managing expectations with investors, it’s important to raise the issue of reinvestment risk; that is, the risk that the proceeds from an investment (principal and interest) that has matured or been called are required to be reinvested at a lower rate by the investor.
Reinvestment risk increases in the loan space when there is excess demand. Recently, fund flows into loans have been robust, causing the average loan price to rise meaningfully over the past six months (see Figure 2). The percentage of loans trading at or above par has also been rising. This has created a scenario where borrowers refinance or reprice their loans at lower rates – introducing reinvestment risk to investors.
Figure 2: Loan repricing volume & % of loans trading above par
Source: Credit Suisse, December 31, 2016
It’s also important to note that because of the high level of security from being senior in priority for repayment, senior loan investors give up prepayment protection. As a result, loans can generally be prepaid by the borrower at any time without penalty, keeping trading prices anchored close to par.
Figure 2 shows that, in the latter half of 2016, the percentage of loans trading above par started to increase and the percentage of loans being repriced also increased. A similar trend occurred in 2013 during the “taper tantrum” when bond yields spiked.
As a result, senior loan investors expecting to receive outsized coupons from a rising LIBOR may be disappointed since loan spreads will tighten as a result of refinancing activity. Senior loan investors should therefore be content with clipping a 4% to 6% coupon, while receiving low price volatility and downside protection. During a period of rising rates, these types of returns are attractive when compared to the performance of traditional fixed income alternatives.
3. Taking an active approach as repricing activity grows can protect investors
In the current market, most investors in the loan space may be impacted by reinvestment risk. However, as experienced and active investors, we anticipate this. In our mandates, we have owned some issues that were recently repriced, which included MKS Instruments Inc., Western Digital Corp., Cinemark Holdings Inc., Albertsons Companies Inc., First Data Corp., Coty Inc. and PetSmart Inc. Yet, as rates rise and repricing activity spikes, one of our goals is to keep those coupons that are increasing, while avoiding reinvestment risk as much as possible. To do this, we need to be active. There are three ways we actively mitigate reinvestment risk – a feature that is noticeably absent from passive approaches to investing. These three risk-mitigation strategies are:
a. Buy loans with call protection
We have the ability to put cash to work in either the primary (new issues) or the secondary market (where existing issues are traded).
In the primary market, new issues are typically offered at a discount to par and with six-month prepayment protection. New issues are attractive in the current market when you have about 70% of existing loans trading at or above par. It also provides us with protection from reinvestment risk for six months and provides some ability for trading prices to move above par.
Three ways that active management can seek to mitigate reinvestment risk:
- Buy primary market loans with embedded call protection
- Focus on overlooked mid-market issuers
- Hold floating-rate debt securities with prepayment protection
It’s also important to remember that, at times, the secondary market may hold greater opportunity. When net flows are negative, similar to the pockets we saw in the last couple of years (see Figure 1), the prices of loans in the secondary market are more appealing.
b. Exposure to mid-market companies
Mid-market companies fall between small business and large multinational organizations. You can define a mid-market issue as a company with a loan issue at or less than US$400 million. Examples from our portfolios include:
- Encompass Digital Media Inc., an information technology company that supports broadcast, cable and digital customers;
- Prospect Medical Holdings Inc., a consolidated health care services provider that operates 18 hospitals in five U.S. states.
In our opinion these are solid, creditworthy companies with loans secured by the company’s assets. Most importantly, we believe companies like these have less repricing risk than larger companies. This is because they may be overlooked (fewer analysts are covering them) or loan issuance is too small or not in scope for larger ETFs or mutual funds. In many ways, this resembles the logic found in small- and mid-capitalization equity investment approaches.
Given their smaller following by investors, the trading price of mid-market issues are more anchored at par as funds flow into the loan space. As such, we have found that refinancing risk is lower than the widely followed, larger loans to companies holding household names (e.g., Dell Inc. and Burger King Worldwide Inc.).
c. Consider first lien floating rate bonds
To further protect investors in our mandates, we have the ability to purchase first lien senior secured floating rate bonds that have greater prepayment protection. The greater prepayment protection allows the bond price to rise more easily above par. These bonds also have many of the same characteristics as senior loans, such as:
- floating coupons that are reset every three months;
- first lien position in the capital structure;
- secured by company assets.
Consider two issues in the chart below: a loan and a floating rate bond from Reynolds Consumer Products Inc., which produces consumer packaging and containers, under brands such as Baking Cups, Cut-Rite wax paper and Hefty waste bags:
With all things considered equal in the chart, we see an advantage with the bond and its ability to mitigate reinvestment risk.
Source: Bloomberg, as at January 20, 2017.
Going forward for the next 12- to- 18 months, we see senior loans performing well. However, in a market with robust inflows, we believe reinvestment risk needs to be actively managed to improve outcomes. With this in mind, we continue to avoid any surprises through astute credit selection and maintaining effective diversification in our positions.
For actively managed solutions that provide diversified access to senior loans, retail investors can look to IA Clarington Floating Rate Income Fund or IA Clarington U.S. Dollar Floating Rate Income Fund.
For more information about senior loans, please contact your iA Clarington sales team.
Coupon – The coupon rate is the stated interest rate on a fixed income security that is a percentage of the face value. For example, a 4% coupon on a 10-year bond with a $1000 face value would pay $40 per year.
Downside protection – Downside protection are measures that a portfolio manager takes to minimize loss in the portfolio is markets fall. This is typically accomplished through the purchase of derivatives such as hedges or options.
First lien floating rate bonds – First lien floating rate bonds are bonds that are like senior loans, and have floating coupons that are reset every three months, maintain the first lien position in the capital structure, and are secured by company assets.
Inflationary policies – Inflationary policies are fiscal or monetary strategies enacted by a government for the purpose of expanding the economy, and as result, inflation.
LIBOR rate – LIBOR or ICE LIBOR (Intercontinental Exchange London Interbank Offered Rate) is considered a standard rate around the world for short-term loans.
Mandates – Mandate is a common term typically used in institutional investing that refers to a portfolio or investment strategy.
Primary market A primary market is where securities are issued for the first time; the issuer works with an investment bank to determine the details (including initial price) of the offering.
Reinvestment risk – The risk that the proceeds from an investment (principal and interest) will be reinvested, or refinanced, at a lower rate by the investor.
Senior loans – Senior loans (also referred to as floating rate loans, leveraged loans or syndicated bank loans), are loans that banks make to corporations and then package and sell to investors. They have first claim on assets in the event of a bankcruptcy, and have floating rates that are reset at regular time intervals.
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