In an earlier interview, Bakalar argued that loan funds, which invest in floating-rate senior corporate loans, deliver better returns than high yield bond funds during periods of rising interest rates.
“Rising rates are finally here. That changes everything!” Bakalar, who is based in the US, told FSA during a recent visit to Hong Kong. “We’ve been anticipating rising rates for four years now,” he said, adding that one of the funds he manages, the NN Flex Senior Loan Fund, is structurally designed to perform well in a rising rate environment.
The Flex fund invests in senior secured corporate loans, whose coupon is equal to Libor plus a credit spread. While Libor is expected to rise roughly in line with the federal funds rates determined by the US Fed, certain structural factors have been acting to compress credit spreads, thus trimming the potential growth.
“There is a lot of demand for loans and not enough supply, not enough new loan issues in the market,” Bakalar said. “That has been the case for the last 18-24 months. Not a huge shortage, but just enough to make the market a little more friendly to issuers, giving them more leverage to get better pricing and terms.”
“This is not unusual,” he added. “It happens every time rates are rising and demand comes in. Investors globally are very interested in loans as an asset class.”
Historically, credit spreads constitute a small portion of a loan coupon, Bakalar explained, adding that rising Libor is likely to offset any further credit spread tightening he can foresee.
Syndicated corporate loans have a place in an investment portfolio next to high-yield bonds, with which they share similarities, but from which they differ in several key aspects. While both are a form of corporate debt (the Flex fund’s average credit rating is B+), senior loans pay a floating coupon and are secured by assets. The latter makes them safer in that they are likely to recoup more assets in case of a default.
As a result, loan fund returns tend to be 150 to 200 basis points lower than those of high yield funds, said Bakalar. However, in the global search for yield, high yield bond prices have been inflated to the point that the difference has recently been closer to 100 basis points.
The returns of a loan fund are less volatile than those of other fixed income funds, as their prices do not adjust with rising or falling interest rates. In addition, the loan market is supported by the process of securitisation. Collateralised Loan Obligations (CLOs) are buyers of, on average, 65% of every newly issued loan, according to Bakalar. This steady structural demand contributes to the market’s stability and reduces volatility.
While Bakalar sees significant interest in his fund among US dollar-based investors in the US and around the globe, he says that the costs of hedging into other currencies, around 2.5%, makes it a less attractive proposition for investors operating in other currencies.
The loan market is today pretty much limited to the US, where banks no longer lend to hold the loans on their balance sheets, but syndicate loans for a fee. “Asian banks are not there yet,” Bakalar said. Moreover, bankruptcy laws, which are an essential consideration for such loans, are uniform in the large US market, while that is not the case in the fragmented markets of Asia or Europe.