Talking Heads – Catch the gripping coupons of leveraged loans

This is an audio transcript of the Talking Heads podcast episode Catch the gripping coupons of leveraged loans

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing leveraged loans. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Javier Perez Diaz, Head of Leveraged Loans. Welcome, Javier, and thanks for joining me.

Javier Perez Diaz: Hello, Daniel. Great to be here today.

DM: Financial markets are always interesting, but when we think about what’s happened over the last year and a half, is it safe to say it’s been particularly so? Obviously, significant geopolitical developments, inflation waxing and waning, and central banks moving away from restrictive monetary policy and now slowly starting to loosen .

From your perspective, how [have levered loans as an] asset class navigated all these changes?

JPD:  The external shocks in the global economy over the past two years not only triggered price volatility, but also an opportunity for investors to capture outsized returns.

The loans market has been shaped by two major developments [over this period]. First, the conflict in Ukraine, which triggered a sharp secondary market pullback. Second, the shift in monetary policy dynamics across the US and Europe, which led to a structural reset in yields. These two developments opened significant return prospects for investors.

Indeed, the market pullback of 2022 led to a sizeable window to capture value appreciation. As for the shift in monetary policy, it triggered a considerable increase in long yields, radically boosting the absolute and relative value of the loans asset class.

As you may know, our floating rate instruments – and therefore investors – have benefited from the rising [interest] rate environment. In fact, since January 2022, eurozone short-term interest rates have risen from minus 57 basis points to around 400 basis points in late 2023. This increase has been captured by the loan market thanks to the floating rate coupon of loans.

The challenging market conditions over the last two years also showcased the resilience of loan returns alongside the diversification benefits. To put this in perspective, let’s examine the recent evolution of the loans market.

2022, for instance, provides a good illustration of the diversification benefits of loans since the asset class displayed meaningful return decorrelation versus bonds and equities, which experienced quite some volatility in the wake of the conflict in Ukraine [erupting] and the market correction induced by the shift in monetary policy.

Following this volatility, the loans market rebounded in 2023 and delivered double-digit returns of more than 13%. The exceptional performance can be explained by the conjunction of two major return drivers.

First, the high rates trajectory mechanically boosted loan coupon income. Second, the sharp rebound of secondary market prices, which was essentially reflective of the broad market correction overdone recession fears. Market momentum this year continues to be solid: loan returns for the first five months stand at 4% to 5%, which, in the absence of unexpected shocks, should lead to another strong year for the asset class.

Altogether, the loans market continues to show its long-standing track record of return resilience. Over the last 17 years, loans posted only two years of negative returns, both largely offset by subsequent years of sharp rebounds.

DM: Javier, you mentioned how the returns in 2023 were quite strong. That, though, raises the inevitable question: ‘Is it too late to be looking at this asset class – has the best time already passed?’ Is this still a good time to be investing in leveraged loans? And what are some of the key features that investors should be keeping in mind?

JPD: The window for outsized returns is indeed behind us. The case for loans has shifted from a value trade towards more of a carry trade.

Despite this, loan yields continue to be attractive thanks to the elevated coupons. In fact, the current average gross yield of the European and US loans markets stands at 8% to 10%, which is competitive in the current capital market environment.

Another aspect worth mentioning is the quality of its yield profile. Loan yields these days are mainly driven by coupon income and less so by market value appreciation potential. This provides investors with significant return visibility as loan coupons are contractual and hence deliver steady income.

If we look at the European market, for instance, the current average coupon stands at around 7.7%, which contributes over 90% of the 8.4% gross yield embedded nowadays in the loans market in this region.

We’re constructive about the outlook. The higher-for-longer rates scenario suggests that conditions in the market should stay attractive.

From a risk perspective, the global economy seems to be leaning towards a soft landing, which should limit loan defaults and accordingly translate into attractive risk-adjusted returns for loans.

Beyond market timing considerations, we believe investors should contemplate adding loans to their asset allocation mix on the back of a number of reasons. First, loans offer potential to capture high income and therefore positive real returns through a steady stream of coupon income. Second, the floating rate nature of loans provides an efficient hedge against inflation and interest-rate risk. Third, loans are senior secured instruments and a defensive approach to diversifying into corporate credit.

Finally, loans provide diversification benefits to broader investment portfolios through a significant return decorrelation versus mainstream asset classes. The overall size, debt and liquidity of the loans market are comparable to those observed in the high yield [bond] market.

From an asset allocation perspective, loans provide a middle ground position in between listed bonds and private debt. And to some extent, the value proposition of the asset class combines the best of both worlds, namely attractive yield and diversification opportunities wrapped under liquid, actively managed portfolios.

DM: The environment has been challenging for portfolio managers over the last couple of years. How has that changed the way you go about managing your portfolio?

JPD: Our portfolio management approach entails an in-depth assessment of the macroeconomic context, which plays in turn a central role in our credit selection and sector allocation decision-making process.

Looking at the current conditions, it seems that the global economy is heading towards a soft-landing on the back of easing monetary conditions, improving real incomes and decreasing supply constraints, among others. This should in principle reduce the risk of a sharp credit downturn.

However, downside risks still exist. Inflationary pressures might prove persistent. Geopolitical tensions may take new turns or political risks can eventually materialise. Given this backdrop, our portfolio management approach has evolved along a number of axes.

To start with, the focus of our investment strategy has shifted towards carry optimisation. The return profile of the asset class is largely concentrated on the coupon component. The universe of loans trading at a minimum discount is limited and involves rather difficult credit stories. Our portfolio construction endeavours have evolved to privilege three objectives.

First, we’re seeking to expand idiosyncratic risk diversification

Second, we have tactically reoriented risk taking towards more balanced risk profiles, which typically involve loan issuers positioned in the middle of the rating distribution. Third, we have reshuffled sector allocation to focus more on defensive, resilient industries such as education, healthcare, telecoms or technology, while becoming more cautious on cyclical activities such as retail or chemicals.

In terms of individual credit selection, we’re paying particular attention to pricing power, supply chain dislocation, capital structure sustainability, refinancing risk – very important – and financial flexibility. These elements are critical to assess the overall credit quality of issuers and their potential default risks.

We are spending a great deal of time looking at loan documentation provisions such as mandatory prepayment clauses. These features are key to evaluate the legal protection and control that loan investors have over the assets and excess cash flow of borrowing companies.

In summary, our approach has shifted towards a more defensive portfolio construction style involving deeper, idiosyncratic risk diversification, disciplined risk taking, and a rather cautious sector allocation approach.

DM: Javier, thank you very much for joining me.

JPD: Thank you, Daniel. It was my pleasure to be here.