Why higher interest rates could draw yield-seekers to leveraged loans

Mark Boyadjian, senior vice president, Franklin Templeton Fixed Income Group.

The prospects for the US Federal Reserve (Fed) raising its benchmark lending rate this year appeared dim until surprisingly positive economic reports prompted the Fed to hint at its July meeting that rate rises could be coming soon. It remains to be seen if the Fed will raise rates at its upcoming September or December meetings, but from our perspective, the importance of a Fed rate hike down the road is its impact upon credit quality. Our view is that a rise in interest rates may cause credit quality in the leveraged loan space to deteriorate—something we need to be cognizant of in terms of our portfolio risk-management strategy.

If interest rates rise, we believe the number of investors seeking leveraged loans could surge because of an expectation that higher short-term interest rates will create a higher income stream. We think this potential increased demand could create a shortage of leveraged loans.

Floating-rate debt market

The floating-rate debt market consists of below-investment-grade credit quality loans that are arranged by banks and other financial institutions to help companies to, among other things, 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 and lenders a degree of potential credit risk protection.

Floating-rate debt goes by many names which can be used interchangeably, including: leveraged loans, bank loans, syndicated leveraged loans and floating-rate bank loans.

When demand outstrips supply, the companies from whom we are purchasing loans typically tend to relax their covenants and the credit provisions that are built in to protect the lenders, making it easier for more marginal borrowers to secure loans.

I think it’s important to note that leveraged loans are generally not investment grade, which means ratings agencies have determined borrowers already are taking a risk by lending them money. We believe that having a possible deluge of perhaps unqualified borrowers flood the market will make fundamental and independent research even more important for potential investors in this asset class.

In anticipation of rising interest rates and the potential for a corresponding decrease in credit quality, we have generally been reducing our exposure to what we call middle-tier loans, which ratings agencies have given a B rating. At the same time, we’ve generally been increasing our exposure to upper-tier loans, which have been given a BB rating.

We also have also been seeking to reduce the risk in our portfolios by paying attention to three important variables when making investing decisions. First, we determine what our priority would be on the repayment schedule. Leveraged loans have senior status, which means owners of these loans will be among the first to recover an investment if the company defaults or files for bankruptcy. Second, we calculate whether the company has enough assets for us to recover our investment in the event of a default or bankruptcy. Third, we assess the company’s liquidity levels.

A leveraged-loan case study

When commodity prices tumbled last year, the price of a loan issued to a large Australian iron ore company experienced a corresponding slump, dropping by 30% at one point.1However, we saw no evidence that the company’s financial stability had changed significantly, so we felt confident that the company would be able to handle its credit obligations. In our view, the loan price had dropped because the company’s business was connected to a particular commodity that was declining in price.

Nevertheless, we analyzed the company’s operations and tried to determine how low the price of iron ore would have to fall to essentially break the company. The price levels we arrived at were so far below what we thought was realistically possible for the market to reach, so we continued to hold on to the position.

This company is an example of a credit that goes to the heart of our fundamental and independent research. We don’t base our investment decisions on what is comfortable or uncomfortable for us to own. When commodity prices imploded during the second half of 2015, it wasn’t uncommon for managers to exit positions because they didn’t want to make the effort or take the time to explain to their clients why they were holding an asset that dropped by one-third in a few months. It’s likely that the immediate assumption of many clients would be that there must be something wrong with the holding. But, in this case, we believe it had more to do with fear as opposed to fundamental analysis of what this particular investment was actually worth.

Leveraged loans versus High-yield bonds

Fears about credit quality aside, we believe the loans of companies that are vetted properly will likely perform well if interest rates rise. In general, leveraged loans are not interest-rate sensitive because they’re short-term, floating-rate instruments.

I’m often asked how leveraged loans stack up against high-yield corporate bonds when rates rise. The only difference between the two, in our opinion, is that leveraged loans have very little interest-rate risk and generally much lower volatility. Higher interest rates would likely favor leveraged loans over high-yield bonds because the bonds typically have fixed durations.2

We think leveraged loans offer attractive yield potential—nearly as good as high-yield bonds, but unlike high-yield bonds, leveraged loans usually don’t offer principal appreciation because they are refinanceable, or callable. As with mortgage holders, leveraged-loan borrowers take advantage of lower interest rates by refinancing or repricing their loans. It’s rare to see leveraged loans trading consistently above 101% or 102% of par value.3

However, I would argue very strongly that the principal appreciation potential in high-yield bonds comes with elevated risk. So, all else being equal, high-yield bonds have potential for investors who seek to benefit from principal appreciation as rates decline, but ultimately the only way they will be able to achieve their yield target is by taking on greater credit risk.

Whether interest rates are rising or falling, we continue to rely on our fundamental research as we seek to limit our credit risk while we aim to provide investors with a high level of current income and preservation of capital.

1. Source: Bloomberg LP.
2. Duration is a measurement of a bond’s—or a portfolio’s—sensitivity to interest-rate movements.
3. Par value represents the face value of a bond.