Is today a good day to invest? Who knows? Timing a recovery or picking a bottom is a loser’s game. It’s like playing the lottery. Someone has to win, but why isn’t it ever me? An investor who diversifies across multiple strategies and who takes a patient, long term view, especially during times like these, potentially stands to realize a profitable return on his investments.
Since the first bank loan mutual fund was launched in the late 1980s, bank loans (or corporate loans) have been an important part of a well diversified fixed income portfolio. Historically, an investor could expect to receive a positive annual return on his bank loan mutual fund investment regardless of interest rate movements or weakness in the broader economy. A look at the CS Loan Index supports this view. For 15 years since its inception in 1992, the CS Loan Index never had a negative annual return, even during periods of incredible volatility in equities and fixed income.
The relative stability of bank loan prices stems from two sources. First, loan interest rates are floating. Unlike fixed rate bonds, the rate charged on a loan fluctuates as interest rates change, while loan prices remain steady. Fixed rate bonds behave in opposite fashion. For example, as interest rates rise, bond prices drop while the coupon remains fixed.
The second source of stability stems from where loans are positioned in a borrower’s capital structure and their lien on assets. Loans are the most senior obligation that a corporate borrower must pay. Furthermore, loans are typically secured with substantially all of the company’s assets. Seniority and security add a significant layer of safety when compared to our more volatile high yield bond cousins.
So what happened?
Beginning with Lehman Brother’s failure in September 2008, we witnessed a complete collapse in the loan market. Everyone – mutual funds, insurance companies, banks and institutional money managers became sellers. Hedge Funds, which also heavily invested in corporate loans, became forced sellers as they struggled to meet redemption requests. Prices plummeted 25 percent. By the end of November last year, the average price for a non-defaulted loan was 65 percent.
Just how irrational was this? Last year Moody’s published a study in which they estimated that defaulted loans would recover 67 percent on every dollar. Yes, loans were trading below their recovery value. If Moody’s analysis is correct, this would mean an investor would not lose any of his investment even with 100 percent defaults. For the record, the actual loan default rate for the last twelve months ended November 2008 was a whopping 4 percent.
Fundamentals or technical?
Clearly this recession is more severe than 2001 through 2002’s hiccup and the credit crunch combined with depressed earnings will likely push the default rate to new highs. A 10 percent default rate for this year is realistic; 15 percent is a possibility. I think these assumptions are reasonable. Defaults peaked at around 10 percent during the 1990 recession and hit as high as 15 percent in 1933, the worst default year of the Great Depression.
The fundamental risks of investing, particularly during a recession, should never be ignored. But periods of great volatility often create great opportunities. Unlike many other fixed income markets, the loan market’s exponential growth has been fueled by cheap credit made available to institutional investors. As this cheap credit expired or was suddenly pulled, institutions were forced to sell their loan investments. We believe that this technical phenomenon – more than fundamentals – is what has pushed loan values to historic lows.
Is the worst behind us?
Floating rate, senior secured bank loans have long been an important part of this diversified fixed income strategy. The steep discount in loan prices, driven largely by forced selling, is merely frosting on the cake. Utilizing a mutual fund to gain exposure to bank loans provides diversification and access to professional money management.
Mike Bacevich is portfolio manager of the Hartford Floating Rate Fund and managing director of the Hartford Investment Management Company.