The floating rate nature of loans is one of the distinguishing features of the asset class. Loans pay a two-part coupon – a floating market base rate, plus a set credit spread. The floating market base rate, typically the London Interbank Offered Rate (LIBOR), has surged in 2018 (Figure 1). What makes this increase standout relative to other periods is that, particularly for 3-month LIBOR, the rate appears to reflect more than merely the market’s prediction of the next short-term rate move by the U.S. Federal Reserve Board, with a widening between 1-month and 3-month LIBOR over recent months.
Source: Bloomberg; as of March, 20, 2018.
Drivers of the Changes in LIBOR
LIBOR has historically provided a relatively accurate forecast of forward short-term rate movements. Although the federal funds rate increased another 25 basis points on March 19th, 3 Month LIBOR has increased 55 bps over the YTD period. There is no universal agreement as to the cause of the sudden steepness of the LIBOR curve. While a single cause is difficult to pinpoint, we believe the increase is likely due to the collision of a few separate macroeconomic factors and the resulting magnification on the market technicals for short-dated paper related to those events.
A few of the most common arguments for the dramatic increase in LIBOR include:
- A material increase in the issuance of U.S. Treasury bills over the last month, likely due to the passage of the debt limit suspension period, as well as a seasonal increase in bill supply needed to finance tax refunds.
- Corporations repatriating cash and selling short-dated U.S. Dollar-denominated credit following recent U.S. tax reform in preparation for tax liability payments, share buybacks, capital expenditure, and/or debt paydowns.
- The run-off of the Fed’s balance sheet, which may be placing marginal upward pressure on funding rates.
The second and third arguments are probably the most likely factors. However, all of these arguments point to technical factors as the culprits for recent widening, as opposed to an indication of fundamental banking stress.
Regardless of the driver, the impact to loans relative to high yield bonds has been noticeable. The weighted average coupon of the S&P/LSTA Leveraged Loan Index has increased to over 5% so far this year, with a 1.41% YTD total return (as of March 21). High yield bonds have lagged as the Bloomberg Barclays U.S. High Yield Index returned -0.74% YTD (as of March 21).
This has begun to pique the interest of retail investors, who have taken notice with moderate, consistent inflows over the YTD period. We believe that both retail and institutional investors will view the forward gross yield expectation for senior loans very positively, which is likely to increase demand for the asset class in the coming months.
Headwind to Corporate Borrowers?
Higher short-term rates are obviously beneficial to loan returns. However, will the increase in LIBOR adversely affect the ability of loan issuers to make their coupon payments? While we believe that there is some forward interest expense increase, we do not believe that increasing LIBOR will be a significant headwind to the majority of corporate borrowers over the near term for the following reasons:
- Interest rate coverage levels are still attractive relative to leverage levels (Figure 2), and earnings growth for most issuers remains reasonably healthy (a function of generally good economic growth).
- Some issuers use interest rate swaps to fix out their floating rate debt. Additionally, many of these issuers also have bonds in their capital structure, which means that not all of their debt is tied to a floating base rate.
- Credit agreements often permit issuers to choose the term of the base rate used in calculating coupons, and issuers may switch to 1-month LIBOR from 3-month LIBOR if the basis between the two terms is wide enough. That basis reflects the difference between 3-month LIBOR and the expected average of 1-month LIBOR over the next 3 months, assuming 1-month LIBOR follows the forward curve. Currently, that differential is wide enough that many issuers may choose to move to 1-month LIBOR.
All of that being said, rising borrowing costs are likely to provide a heightened challenge to the most leveraged borrowers in the market, i.e., those typically rated CCC or below.
Source: S&P Capital IQ; as of December 31, 2017
While we believe some of the recent pace is likely to normalize as the shorter-term technical factors adjust, we do not believe that we will see a reversal of LIBOR’s current course. As a result, loan coupons should continue to reset higher in the coming months. This should continue to support loan returns for 2018 without, all things equal, the potential price volatility that will likely challenge traditional fixed income asset classes. While borrowers will see an increase in their interest obligations, this should not increase general default rate expectations. We view this trend as a positive for loan investors and, in turn, expect to see increased demand for the asset class in the near term.
Past performance does not guarantee future results.
This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) changes in laws and regulations and (4) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.