Opinion

The tide has turned… the solution for investors is to move into floating rate loans

Thomas Majewski

Founder & managing partner Eagle Point Credit Management

While loans enjoyed their 28th year of positive total returns over the past 30 years, the first-place trophy in the fixed income non-structured products category last year went to holders of fixed rate securities. The Barclays Aggregate Bond Index delivered a total return of 7.5% — integer multiples of the Agg’s coupon — as rates dropped sharply and credit concerns waned.

The bull case for 2021 is that we are in the early stages of a new expansionary period. The rates market is already beginning to reflect an inflationary view. After last year’s rally, as of the time of writing, 10-year treasury notes have widened by 20 basis points this year and it’s hard not to see that trend continuing.

With the rates tide having turned, the Agg has given back about 10% of last year’s return so far this year. If rates keep moving the way they have so far in January, it’s quite conceivable that we will see the Agg deliver a total return of negative 5% or worse in 2021.

Investors flock to loan funds

There is a phrase from half a decade ago that we suspect some returning loan investors may have forgotten: “floaters that don’t float”. While the long end of the curve is moving up, with the Fed’s stated goals, it’s more difficult to see much movement at the short end of the curve this year.

Perhaps the goal for loan investors this year is simply to earn the coupon — and to avoid rate-based losses in long-dated fixed rate bonds. Although there can continue to be some additional increases in loan prices, it is difficult to see much rate-based upside in loans — this year, at least.

Other investors, particularly those which prefer investment grade ratings, are moving into CLO debt. While not to the same extent as a typical loan issuance, the debt tranches of many CLOs today are oversubscribed at syndication and investors are jockeying for allocations.

If the steeper curve and increasing inflation outlook is correct, how will CLOs be impacted?

Borrowers will face higher operating costs as the price of many of their inputs rise. Depending on a borrower’s competitive position, they may be able to pass those increased costs on to their customers. Or they may not and margins will be squeezed. Many companies have ample liquidity, so we don’t anticipate many inflation-driven defaults this year. In our view, a bear case for 2021 could see the market ending up with a few more zombie companies — where the companies are not worth the face amount of their debt, but where they have enough cash flow to service it.

The CLO market is similar to 2018

What is different from 2018, however, is the type of capital driving the CLO market. Whereas we estimate that about half of CLOs issued in 2018 were supported by captive equity capital (which in some cases might be less return sensitive), we expect that number to be much lower this year. That might slow CLO formation a bit, but we believe it will help keep CLO liability levels more in line with the trends in the loan market.