Beyond Bulls & Bears

Looking at Leverage Outside the Box

Yield-seeking investors have been boxed in by the near-zero US rate environment, and it seems like there are few ways out. But for those willing to set aside preconceived ideas about the word “leverage,” the lesser-known leveraged loans category may be an alternative to consider in the credit space. Mark Boyadjian, senior vice president and director of our Franklin Floating Rate Debt Group, spoke to us recently about what these often-misunderstood vehicles are and what yield-seeking investors need to know before they take the plunge. 

Leveraged Loans 101

For the uninitiated, the market of leveraged loans (also known as bank, senior or floating-rate loans) consists of below investment-grade credit quality loans that are arranged by banks and other financial institutions to help companies finance acquisitions, recapitalizations, or other highly leveraged transactions. 

Although leveraged loans are considered below-investment-grade in credit quality, typically their “senior” and “secured” status can provide investors/lenders a valuable degree of potential credit risk protection.  Leveraged loans are senior in the capital structure, and in the case of default, these “senior” investor/lenders rank above other credit obligations of the company.  Also, collateral that may include real estate, equipment, inventory, and accounts receivables also typically backs leveraged loans.

All About Income

Loans generally pay a floating rate coupon, with two components: 1) the underlying, resetting floating-rate benchmark, which is typically three-month London Interbank Offered Rate (LIBOR) and 2) a credit spread that the borrower agrees to pay the investor. Leveraged loans are continuously callable, which means that the issuer can repay them prior to maturity, typically in order to reissue the debt at more attractive interest rates. According to Boyadjian, this is an important factor to consider when demand is significantly greater than supply in the market.

Mark Boyadjian

“This is a particularly challenging time, because income levels are declining and demand is exceeding supply. One risk that I think people need to focus on is the immediate amount of cash that’s flowing into the asset class, and what implication that has for performance. If that underlying benchmark, known as LIBOR, doesn’t start to rise, the income level is going to decline. And that means the potential total return is going to decline. As long as the demand exists, borrowers have the incentive to refinance, because, essentially, what’s happening is, the loan prices appreciate as more cash is seeking to purchase a stable supply of loans. And as they [prices] increase, the message that’s being communicated back to the borrower is that the market is willing to lend to you at a lower level of interest rates. So, the borrowers will refinance. The investor who purchased a loan at a significant premium to par will experience a principal loss, because it’ll be refinanced at par, and then they’ll have a lower spread. The problem with this demand-supply imbalance is that, I would argue, it’s path-dependent—meaning, you have to be very cognizant of where you started versus where you are and where you might be going. [perfect_quotes id=”1936″]

“Investors are not necessarily behaving rationally. So, the greatest challenge we face is making active decisions about whether we are willing to forgo income because the risks are not being compensated in the face of every other investor willing to take that risk because their concern is, ‘I just need to invest my cash.’ It’s a difficult time, but one that I think, relative to other alternatives in the credit space, can provide potential opportunities for investors.”

To put it in smaller bites, Boyadjian says it’s akin to a mortgage which allows the homeowner the ability to refinance at any time. When interest rates drop to low levels, it encourages more refinancing activity. In the case of the leveraged loan market, the investor receives less income, and price appreciation potential is limited.

Considerations for Investors – Relative Value and Absolute Return

So what should investors consider about this investment option, from a relative value and absolute return perspective? More from Boyadjian.

“That’s a good distinction to make, because I would urge people to think of it in the context of a relative yield, as opposed to an absolute yield.  It’s important to understand that for many loans in the market, you really don’t own a floating-rate asset at this point in time. In a period of low interest rates, most loans have come with a LIBOR floor – an interest rate that the borrower or the seller agrees to pay, that is typically above the actual LIBOR rate. It’s a floating-rate asset if LIBOR rises above this floor, this LIBOR floor, but, for all intents and purposes, it’s a fixed-rate asset—or, if you have no LIBOR floor, it’s a floating-rate asset with a very low level on the underlying index.

“So, if you’re looking at this from an absolute return perspective, you may be getting a higher yield than what you’d be getting, for example, in other comparable low-duration alternatives. But that additional yield is a function of this credit risk that you’re accepting, which is, the borrower’s credit risk, and you’re getting compensated for that.

“But I urge investors to consider the asset class from a relative value perspective and I say that because, with every other credit alternative, you have interest rate risk.  And, notwithstanding my comment about this being a fixed-rate asset with the LIBOR floor, your interest rate risk is a function of this Treasury yield curve.  So, if rates start to rise with other assets that are priced off that Treasury curve, you will see negative principal return from that increase in rates, because most fixed-income assets have interest rate sensitivity, known as duration.

“The duration on a loan is typically very low. And, in fact, it might even be negative, because the only risk we’re really taking, other than this continuously callable option that we’re short to the borrower, is the credit risk. So, if rates rise or decline, our price sensitivity is much less, if even any, relative to a high-yield alternative.”

How Big a Role Does Default Risk Play?

But what about default risk? Here’s Boyadjian’s read on the current environment.

“The (default) outlook, at this point in time, appears to us to be fairly benign. Many investors have the expectation that we’ll stay at a default rate between two to three percent, which, is lower than the long-term average and historically, is acceptable for a given level of compensation, which, typically is the income stream that you’re receiving for the loans.  And so we spend a lot of energy and attention on understanding that particular risk—whether we’re getting compensated for it, whether we’re willing to accept a term that we think takes a protection away from us, to enforce that discipline that we need to have from the borrower to not default.

The outlook for defaults is an important driver for the valuations of the asset class. But one of the factors that investors need to consider is that performance is not just driven by defaults. In fact, much of what we’re seeing in the current environment is coming from investors who have expectations about rates rising, and, therefore, are looking for a way to protect themselves from the negative principal effects of higher rates on fixed-rate assets, such as high-yield bonds. 
“So, it’s really important for investors to consider and understand what they expect from this asset class, but, perhaps more importantly, to appreciate the fact that, even if defaults do rise, you will and should expect some form of price decline, as the market readjusts to that. But it should be less than what you would expect or experience in a bond that’s further subordinated.”

The multi-layered interplay of the forces at work in the leveraged loan space may be a bit confusing, but they don’t have to be intimidating. If you’re interested in busting out of the low-yield box, floating-rate or leveraged loans may be an investment option to consider. As Sir John Templeton once said: “Investigate before you invest.” [php function = 1]

Learn about Franklin Floating Rate Daily Access Fund, a fund that invests primarily in senior secured floating rate loans.

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What are the Risks?

All investments involve risks, including the possible loss of principal.  Investors should be aware that the Franklin Floating Rate Daily Access Fund’s share price and yield will fluctuate with market conditions. The fund should not be considered an alternative to money market funds or certificates of deposit (CDs). The floating-rate loans and debt securities in which the fund invests tend to be rated below investment grade. Investing in higher-yielding, lower-rated, floating-rate loans and debt securities involves greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy. Interest earned on floating-rate loans varies with changes in prevailing interest rates. Therefore, while floating-rate loans offer higher interest income when interest rates rise, they will also generate less income when interest rates decline. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. These and other risks are discussed in the fund’s  prospectus.