Why Bank Loans Look Attractive In Today’s Market

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Written by Reema Agarwal, Chartered Financial Analyst, Director, Floating Debt Ratio, Franklin Templeton Fixed Income

The technical and fundamental picture looks favorable for bank loans for a number of reasons, according to Reema Agarwal, director of fixed income for Franklin Templeton Fixed Income. She says current spreads look attractive amid what is likely to be a period of monetary tightening throughout the year, and periods of volatility should be considered in buying opportunities.

Note: The video below was recorded in December 2021. Thus references to “next year” refer to 2022.

With the exception of a short pause around the discovery of the COVID-19 Omicron variant, loan spreads have continued their tightly flat path, more so since mid-September, when expectations about a tapering US Federal Reserve and interest rate hikes began to increase, providing tailwinds to the high-risk bank loan sector. variable interest. Technical conditions remain sound – the issuance of CLOs and retail demand has supported loan rates. While there may be a slump in loan market activity in the early part of 2022 as market participants digest the implications of moving from the London Interbank Offered Rate (LIBOR) to the Secured Overnight Financing Rate (SOFR), we believe that CLOs It will continue to be an attractive option for investors that supports loan valuations and provides minimum loan rates. Overall, retail flows have been consistently positive in 2021, driven by the anticipation of higher interest rates.1 We believe current loan margins are attractive, and technical conditions remain favorable to narrow the path. We also believe that expectations about the timing of an interest rate hike will be a major determinant of credit market sentiment.

As expected, the path to full recovery was uneven across industries and exporters as economies fully reopened, depending on trends in office versus remote work, safety constraints on indoor and outdoor capacity in various sectors and eventual demand for activities and services reopened. The office supply business has been slow to recover, as have some space and entertainment issuers such as gyms and movie theaters. Supply chain disruptions and labor and input cost inflation have been headwinds in some cases as well. Demand for chemicals, packaging and construction materials was strong, but margins were negatively impacted by higher costs for resin and other inputs and/or higher container rates. Many issuers were able to pay price increases to offset part or all of the higher costs, albeit with delays. FMCG, retail and food exporters also faced rising input costs and labor inflation, with varying capabilities to pass price increases.

On the other hand, some exporters benefit. Commodity exporters are clearly benefiting from inflation, and loan rates have risen further in these sectors in 2021, although we note that these industries only account for 5% of the loan market. We are aware of the cyclical upheavals that may be set back for some sectors that have thrived during the pandemic. At the same time, we are looking for loan issuers with business models that are most likely to benefit from permanent changes in consumption patterns/behaviours and work habits in a post-COVID-19 world.

If we observe volatility due to supply chain issues and cost inflation, changing expectations about the timing of price hikes, or potential macroeconomic challenges posed by the Omicron variable, on a selective basis, we will consider periods as buying opportunities, as we believe companies fundamentals are still healthy.

In general, we prefer B-rated loans, especially those with LIBOR floors. With the potential for price and interest rate hikes to be higher than in the past several years, we maintain our view that industries with difficult fundamentals can be negatively affected the most, especially those with persistent supply chain issues. Amid the issuer’s own risks, a wise security choice remains critical, in our view.

Despite the potential headwinds that persistent inflationary pressures could bring, we continue to believe that supply chain disruptions and inflation can delay, but not impede, a full recovery. Nor do we expect a high probability of widespread fundamental weakness in the loan market over the next year, especially to the point where it outperforms the significant technical tailwind of floating-rate assets. We maintain our constructive view of the bank loan segment – over the next twelve months, technical conditions should remain strong and fundamentals broadly constructive with default rates weak, against the backdrop of an increasing interest rate environment.

What are the risks?

All investments involve risks, including the possibility of losing capital. Bond prices generally move in the opposite direction to interest rates. Thus, when the bond prices in an investment portfolio adjust to higher interest rates, the value of the portfolio may fall. Investments in low-rated bonds have a higher risk of default and capital loss. Risks related to foreign investment, including currency fluctuations, economic instability, and political developments. Investments in emerging markets involve increased risks related to the same factors, as well as those associated with the size of these smaller markets and lower liquidity. Floating rate loans and debt securities tend to be rated below investment grade. Investing in higher-yielding, lower-rated loans and debt securities carries a greater risk of default, which can lead to capital loss—risks that may be exacerbated in a slowing economy. The interest earned on variable rate loans varies with the prevailing interest rates. Therefore, while floating rate loans offer higher interest income when interest rates are higher, they will also generate lower interest income when interest rates are lower. Changes in the financial strength of the issuer of a bond or in the credit rating of a bond may affect its value.

1. Sources: Franklin Templeton Fixed Income Research, JP Morgan. As of October 2021. There is no guarantee that any estimate, forecast or forecast will be achieved.

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