Game of loans Chief Investment Office Americas, Wealth Management 24 October 217 Philipp Schöttler, strategist; Carolina Corvalan, CFA, strategist; Barry McAlinden, CFA, Senior Fixed Income Strategist Americas, barry.mcalinden@ubs.com; Leslie Falconio, Senior Fixed Income Strategist Americas, leslie.falconio@ubs.com We recommend exposure to US senior loans as a fixed income theme and also hold a tactical overweight position in the asset class within our moderate and aggressive Fixed Income Strategist portfolios. US loans have achieved total returns of 3.5% year-to-date. While this is in line with our forecast at the start of the year, US loans have been underperforming other credit asset classes. Here we explore the reasons for this, and update our asset class outlook. Over the next six months, we think the current yield of 5. 5.5% offered by US loans is still attractive against a supportive fundamental backdrop. But as valuations have become less appealing in this year, we are keeping a close eye on potential risks, and loan investors should beware the illiquidity risk inherent in senior loans. Like the queens and kings in the popular TV show that inspired the title of this report, US loans have been in a tug-of-war since the beginning of this year. On the one hand, short-term US interest rates (as measured by the three-month LIBOR rate) have risen from 1.% to 1.4%, supporting the asset class thanks to its floating-rate nature. On the other hand, the popularity of loans with investors has allowed issuers to reprice outstanding loans at lower coupons, which has weighed on average prices and credit spreads at the same time (see Box 1 for details on repricing activity). As a result, loan yields which many investors had expected to rise in line with LIBOR rates have remained flat year-to-date (YTD). This might help explain the fall in retail fund inflows into the asset class as the year progressed. The good news is that periods of strong repricing activity are usually followed by calmer times. In recent months, the "repricing wave" has lost momentum, as can be seen in Fig. 2, and we expect the drag on coupons to diminish but not disappear in the months ahead. US senior loans have also not done well when compared to other credit asset classes. US loans have achieved a total return of 3.5% since the beginning of the year, which is pretty much in line with our expectations for carry-like returns. At the same time, US high yield (HY) bonds have delivered 7.5%, surprising to the upside. Fig. 1: US loan yield (to-3-year) components Yields in % 3 25 2 15 1 5 22 23 24 25 26 USD 3M LIBOR 27 28 US loan yield (to 3-year) 29 21 211 212 213 214 215 US loan spread over LIBOR Source: Bloomberg, S&P LCD, UBS, as of 13 October 217. Box 1: What does repricing mean? Loan issuers have the right to call their loans at any time at par value (i.e. USD 1) or slightly above. Therefore, loan prices don't usually rise materially above USD 1. This exposes investors to the risk of prepayment, particularly when funding conditions are favorable and loans are in high demand, as has been the case so far in 217. Consider the example of a loan with a coupon of 5%, trading at USD 99 at the beginning of the year. As more and more investors look for income-generating assets, the price of the loan rises to USD 1.5. At this point, the issuer might find it beneficial to call the loan and negotiate more attractive conditions. The issuer could issue a new loan at USD 1 with a coupon below 5%, saving interest expenses. As this loan is "repriced" within a broader loan index, the average coupon (and spread) of the index would fall, and at the same time its average price would decline. Repricing is thus the exception to the rule that falling credit spreads lead to rising prices, all else equal. When many loans get repriced at the same time, there can be a big impact on the index. This is what happened this year as 35% of outstanding loans have been repriced. Consequently, the average spread has declined by 5 basis points (bps) year-to-date, while average loan prices have not changed. Source: UBS as of 2 October 217. 216 This report has been prepared by UBS Switzerland AG and UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures at the end of the document.
US HY bonds should be expected to do better than loans in a strong "risk-on" market environment, as they have higher credit risk due to their lower average credit rating and their subordination relative to senior loans. Furthermore, high yield bonds are less call-constrained compared to loans, giving them more price upside. Finally, the significantly longer duration of bonds versus loans has been a slight advantage as well, as US Treasury yields at the longer end of the yield curve have declined somewhat. This comes with the cost of larger downside risks and higher volatility for HY bonds in the long term (see Fig. 3). Strong fundamentals keep defaults low Loan issuers' earnings rebounded in 2Q17, with average pre-tax earnings growing by 4.7% y/y versus a 1.3% decline in 1Q17. This resulted in the average leverage ratio declining from 5.5x to 5.3x and moving back in line with its norm over the past five years. With the benefit of low interest rates, issuer interest coverage of 4.7x remains better than the historical average of 3.7x. However, the proportion of issuers with very weak interest coverage rose to 11% in 2Q17 from 9% in 1Q17. New large loans issued during 3Q17 had an average pro-forma leverage level of 5.3x, up from 5x during 1H17. Large corporate leveraged buyouts (LBOs) had a pro-forma leverage above 6x, which US regulators have identified as a problem. However, the average equity contribution to LBOs this year remains strong at over 4%. The trailing 12-month default rate for senior loans was 1.5% in September, up just 17bps from the low levels during July and August, when no defaults took place. The loan default rate will likely pick up, particularly if one of the remaining 28-era LBO deals that is under stress enters into bankruptcy. However, this would likely be viewed as a one-off and the default rate should rise moderately to 2% over the next 12 months, which is still below the long-term average of 3%. With the current spread-to-three-year at 49bps and estimated oneyear default losses of 6bps (i.e. based on a recovery rate of 7% and a default rate of 2%), the additional credit risk premium is roughly 35bps. This is pretty much in line with the long-term average credit risk premium of 34bps, and thus not overly expensive. Despite some mixed signals, we believe the fundamental trends should remain benign overall as the US economy grows modestly, conditions for consumers and businesses stay supportive, and the lending environment is accommodative. The rise of covenant-lite loans is another hotly debated topic for loan investors, but we are less concerned about this for now (see Box 2). Ample supply meets strong demand As the repricing wave faded, the volume of newly issued loans took a breather in 3Q17, down 14% versus 2Q and down 37% versus 1Q. The proceeds have been mostly used for M&As, but repricing has dominated the issuance trend since the beginning of the year. Fig. 2: Repricing activity among US loans Repricing volume in USD bn and % of loans trading above par Institutional Loan Repricing Volume ($bn) 7 6 5 4 3 2 1 Jan-12 Aug-12 Mar-13 Oct-13 May-14 Dec-14 Jul-15 Feb-16 Sep-16 Apr-17 Repricing ($bn) % Leveraged Loans Trading Above Par Source: JPMorgan, UBS, as of September 217. Fig. 3: Drawdowns and risk / returns statistics since 21-1% -3% -5% -7% -9% -11% -13% -15% 21 211 212 213 214 215 216 US high yield bonds US loans US high yield bonds US loans Total return p.a. 7.9% 4.9% Volatility p.a. 6.1% 3.4% Return / volatility ratio 1.3 1.44 Source:S&P, BoAML, UBS as of October 217 Fig. 4: US loans price stable since the beginning of the year Average loan index price in USD 15 1 95 9 85 8 75 7 65 6 23 24 25 26 27 28 29 21 211 212 213 214 Average US senior loan price (USD) Source: S&P LCD, Bloomberg, UBS, as of 19 October 217 215 216 9% 8% 7% 6% 5% 4% 3% 2% 1% % 217 % of Loans Trading above Par Chief Investment Office Americas, Wealth Management 24 October 217 2
With USD 42bn issued so far this year, the institutional loan supply for full-year 217 may exceed the record USD 455bn total in 213, according to S&P LCD data. While loan demand has been ample, the combined sources of collateralized loan obligation (CLO) issuance and fund flows have fallen short of the record supply. CLO volumes have already exceeded that of the past two years and fund inflows have amounted to 15% of assets under management YTD. Despite the imbalance, we think the excess net supply only contributed slightly to the underperformance of loans this year, and see the repricing trend as a more significant factor. With the Fed poised to hike rates further, solid demand for floating-rate assets should continue among both CLO and retail fund investors. Keep an eye on the risks The main risks to our constructive outlook on US loans include the Fed tightening policy faster than expected due to a strong, unexpected rise in inflation, more aggressive corporate behavior, and ongoing strong repricing. While it would seem that loan investors should benefit from the faster rise in US LIBOR under the first scenario, tightening financial conditions would lower economic growth expectations, and could pressure company earnings, both from lower top-line growth and higher borrowing costs. Another risk to fundamentals is more aggressive corporate behavior, especially as the credit cycle advances. We are watching several metrics for hints of rising risks, including higher new-issue leverage, a greater proportion of M&As and LBO-related deals, and lower LBO equity contributions. Repricing risk remains a concern, given roughly 65% of US loans are trading at par or above. This suggests that a good portion of these should reprice within the next 12 months despite the fact that 35% of outstanding loans have already been repriced year-to-date. If we assume all loans trading at par or above will reprice within a year, and that these loans are currently trading at a market price of between USD 1.5 and USD 11, this would lower the expected index yield by roughly 2 3bps from 5.4% currently over 12 months. This would reduce, but should not completely offset, the benefit of the rising US LIBOR as the Fed continues to hike rates next year. Box 2: Arc of the covenant-lite Covenant-lite, or "cov-lite", loans are once again popular in the senior loan market. Larger and more liquid loan deals have increasingly taken on this feature, with the proportion of newly issued cov-lite loans remaining in the 7% range over the past few years. The volume of cove-lite loans currently stands at nearly USD 3bn, exceeding the previous peak of USD 262bn in 213. It is not clear whether cov-lite loans are riskier securities, in our view. Regarding recovery rates, Moody's recently pointed out that there has been a lower debt cushion below cov-lite loans, which has declined to 22% versus 33% during 25-216. Broker studies show that cov-lites have less secured debt outstanding, which helps improve their status in the capital hierarchy. We think the trend toward cov-lite issuance is more a structural change in the senior loan market rather than a near-term cyclical concern. Both cov-lite and cov-heavy loans exhibit seniority in the capital structure and are backed by assets, either first or second lien. This should mean better outcomes in case of bankruptcies. The actual recovery data over the past five years shows that loans had recoveries that were about 3 cents on the dollar higher than those of senior unsecured bonds. Source: Moody's, BoAML, UBS, as 2 October 217. Fig. 5: Covenant-lite loan issuance on the rise New issue volume, in USD bn (LHS and % (RHS) 35 3 25 2 15 1 5 212 213 214 215 216 217 YTD Cov-lite volume (LHS) Cov-lite as a % of new institutional loans 8% 7% 6% 5% 4% 3% 2% 1% Source: S&P LCD, Bloomberg, UBS, as of 3 September 217 % Liquidity risk is an inherent feature of the asset class. It is more pronounced during periods of market stress, when investors want to withdraw their funds, as was the case during the 28 financial crisis. When liquidity is very low, loan prices do not necessarily reflect economic reality. When there is a lack of investors willing to bid for a certain loan, a single trade (e.g. by an investor forced to sell a loan) can cause prices to drop sharply below the loan's "fair" value at least temporarily. Investors in the asset class should be comfortable with Chief Investment Office Americas, Wealth Management 24 October 217 3
this risk. It also means that the recommended investment horizon for US loans is relatively long. We suggest that investors regard loans as buy-and-hold investments, generally with a minimum holding period of 12 months. Summary Under our base case of continued moderate economic growth in the US, and still benign lending conditions, US senior loans should continue to fare well over the next six months. Coupon-clipping is expected to be the main source of returns. Price upside is very limited, given the average index price of USD 98 and the ongoing repricing risk. Defaults should rise modestly from the current very low level, but still remain below long-term averages. Fed rate hikes should support coupon income, all else being equal; however, the ongoing repricing risk can still be expected to hurt returns. We estimate this could subtract 2 3bps from the index's yield of 5.4%. This leads us to expect a total return of around 4% over the coming 12 months. We think the risk-reward relative to government bonds still looks appealing. Some sort of US tax reform is likely, which could further boost US Treasury yields and Fed rate hike expectations in the near term. This would likely benefit US loans relative to government bonds over the next six months. So we maintain a tactical overweight in US loans in our moderate and aggressive Fixed Income Strategist portfolios. We will revisit our outlook if 1. valuations become less attractive; 2. our base case on Fed policy becomes significantly more hawkish; 3. our economic base case indicates heightened risks of a downturn; or 4. corporate fundamentals or loan-specific risks deteriorate. In light of the liquidity risk, we recommend that investors include loans as a strategic part of a well-diversified portfolio, with an investment time horizon of at least 12 months. Chief Investment Office Americas, Wealth Management 24 October 217 4
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