Against a backdrop of major supply shocks, higher inflation and rising interest rates, most major credit markets have suffered losses. The global loans market has been no exception, even if the asset class’s defensive characteristics helped contain the drawdown relative to equivalently rated corporate debt.
Despite a challenging year, we believe the asset class is fundamentally sound. Given that loans are floating rate instruments, they should do well when interest rates are rising. In our view, the recent drawdown has created a compelling opportunity for investors to gain additional returns as the market eventually pulls to par. This opportunity is expected to remain open for up to 12 months, so we believe investors should strike while the iron is hot.
The pull to par
Historically, the periods of highest returns occurred in the recovery after market drawdowns. In the past decade, there have been five notable instances.
Global financial crisis (2008-9)
The most serious financial crisis since the Great Depression led to the Great Recession. Financial institutions worldwide suffered severe damage with credit markets experiencing large declines, European loans included.
After the pullback, though, the loans market saw a strong recovery. During a 12-month window between March 2009 and March 2010, the European loans market returned 49%.
Greek debt crisis (2009)
At the beginning of a wider debt crisis across Europe, larger-than-expected Greek budget deficits raised concerns over a Greek sovereign debt default. This led to high volatility across credit markets and sovereign bond yields widened sharply. But over the 11 months between June 2010 and May 2011, the European loans market returned 12.2%.
European sovereign debt crisis
As the Greek debt crisis intensified, similar default concerns emerged for a number of European economies. Defaults ticked up and volatility spiked, exacerbated by a US credit rating downgrade (from AAA to AA+). After the decline, the loans market saw a 12-month bounce between September 2011 and September 2012, with European loans returning 9.45%.
2015-16 market sell-off
Stock prices dropped globally and bond yields rose sharply. Much of the sell-off was driven by concerns over the end of quantitative easing. Following the drawdown, the loans market returned 9.46% between February 2016 and February 2017.
The pandemic and the ensuing lockdowns set off extreme volatility, particularly from mid-February to late-March 2020. Equity markets dropped, loan spreads widened, and credit indices declined, with the European loans market returning -14% in March 2020 alone. From April 2020 to March 2021, the European loans market then returned 21.13%.
European loans prices had declined by around 10% as of the end of Q3 2022 and spreads had widened considerably. This compares with an average rate of return during the aforementioned market disruptions of 20%.
We believe the current period offers investors a compelling opportunity to boost long-term returns. We suggest a US dollar cost averaging approach, whereby investments are made gradually over a number of months or quarters. This is prudent during periods of uncertainty.
It is worth recalling the key characteristics of global loans. Many contribute to the asset class’ resilience and are complementarity within a broader fixed income portfolio. These include its floating rate nature, balanced risk profile, and ability to generate stable income.
Floating rate instruments
The coupon on senior secured corporate loans in Europe generally consists of the Euribor inter-bank lending rate plus a fixed interest margin. This margin represents compensation for the credit risk of the borrower based on their underlying ratings profile and prevailing supply and demand conditions in the market.
Over the past few years, margins for BB/B-rated credits have fluctuated around 300bp. While the margin is set when a loan is issued and is generally fixed, the Euribor rate is typically reset every three months. Hence, when Euribor rises, so does the coupon paid and therefore the returns to investors. These instruments thus embed a hedge against rising rates.
Balanced risk profile
Given their senior secured nature, corporate loans typically provide superior recovery rates in the event of bankruptcy. The average recovery rate has historically been 60-65% for European corporate loans compared with 40-45% for European high-yield bonds.
The return profile of corporate loans also tends to be more stable. Historically, loan returns tend to fall less sharply and more slowly than those of high-yield bonds during periods of market volatility. This lower volatility is partly because most of the incumbent investors are institutional. Moreover, the floating rate nature of the instrument makes it less sensitive to both interest rate movements and price fluctuations due to monetary policy changes.
Stable cash income
Senior secured corporate loans can be a stable source of income for investors. Across market conditions, loans have a record of producing consistent, positive returns.
Looking at the European S&P Leveraged Loan index (euro-denominated), returns have been positive in every year from 2003 to 2021 apart from 2008, at the height of the financial crisis. In 2009, returns reached record highs, more than offsetting any losses in the previous year.
The margins on loans are relatively stable, while the coupon rises as interest rates rise. This may make for a more reliable source of income amid market volatility.
A window of opportunity
Loans offer stable income and a balanced risk return profile, so even in the current environment, they can present a compelling opportunity for investors to capture outsized returns.
There have been several windows in the past where the loans market rebounded strongly after a pullback, resulting in double-digit returns for investors.
After the latest drawdown in the wake of the war in Ukraine and rising inflation concerns, we believe this is another window of opportunity. If investors act swiftly, they could be rewarded with substantial capital gains in addition to attractive coupons.