Leveraged Loans in a Rising Rate Environment – Carry Factor Dominates

Since the end of 2015, the U.S. Federal Reserve has raised the policy rate eight times to currently 2.0%-2.25%. The minutes of the recent September FOMC meeting reiterated the committee’s positive growth outlook and confidence on 2% inflation. Market players continued to catch up on pricing future Fed hikes. Currently the market is implying approximately one more hike in 2018 and two more in 2019.

With expectations of higher rates ahead, leveraged loans remain highly attractive for market participants, due to their feature of coupon reset at a spread over a floating index (mostly the three-month LIBOR rate). In addition, leveraged loans generally provide higher protection than traditional high-yield bonds, since the loans are secured with collateral.  Against that backdrop, we show a few salient characteristics of the S&P/LSTA U.S. Leveraged Loan 100 Index to provide additional color for this segment.

Exhibit 1 compares total and price returns for the index since January 2002 (the index inception). Except during the global financial crisis of 2008-2009, the price return of the index has been stable and flat. In an orderly market, loans don’t provide much price appreciation due to the combination of floating LIBOR rate, lack of call protection, and possible refinancing at lower spreads. However, the index delivered a cumulative 113% on a total return basis over the same period. The figure demonstrates that carry is the dominating source of return historically for leveraged loans over mid- to long-term investment horizons.

Exhibit 2 shows the index yield[1] against the three-month LIBOR and the index’s average LIBOR spread. Though the spreads for loans have decreased since 2016, rising LIBOR rates have more than offset the spread narrowing and have pushed index yield to increase since 2017. The lower loan spreads also partially reflect the improving credit quality of the loan index (see Exhibit 3).

Against the macroeconomic backdrop of future rate hikes and tighter monetary policy, it is not difficult to see why leveraged loans are popular among market participants in search of a protective cushion against rising rates. Our analysis shows that it is important to pay close attention to the yield/carry level of this segment.

[1] Yield for loans is calculated with current coupon adjusted for price discount/premium.

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