On November 13, we met with a group from Alcentra/BNY Mellon in our Walnut Creek offices. Alcentra’s Leland Hart called in to discuss the loan market and the BNY Mellon Floating Rate Income fund (DFLIX). Hart is co-chief investment officer at Alcentra, and he sits on their U.S. Liquid (Loans and High-Yield) Committee. We’ve known him for several years, since his days at BlackRock. Our history of investing with him was a key support of our decision to use BNY Mellon’s loan fund in our model portfolios. (See our original due diligence report on Alcentra’s fund, then under Dreyfus branding.)
The Up-in-Quality Story
Chart courtesy of Alcentra/BNY Mellon.
If we back up a couple of years to when the Federal Reserve began to tighten, retail money began to flow into the loan market on expectations of rising rates. Toward the end of 2018, it became increasingly clear the Fed could not continue tightening. The market started to price in rate cuts. This was later confirmed by the Fed’s U-turn. The retail money that had flowed into loan mutual funds started to exit during the fourth quarter turbulence last year as their rising-rate thesis dissolved and the broader markets fell sharply. Retail outflows continued in 2019.
In our conversation, Hart made some interesting points.
- First, while there was price volatility last fourth quarter, there were no defaults. Loan returns were in line with a 4:1 rule-of-thumb relationship between equity and loan downside: In the fourth quarter, stocks were down 13.6% and loans were down about a quarter of that at 3.5%.
- Second, retail outflows have been more than offset by very consistent collateralized loan obligation (CLO) formation. Importantly, CLOs are never forced sellers and they must substitute any holdings they do sell. Retail investors now make up only 8% of the loan market, so Hart says the potential price impact from further retail outflows should be minimal.
- Finally, through the turbulence, Hart says liquidity was “much better than feared,” though you may not have liked the prices you received in transactions.
This year, credit markets have become starkly bifurcated. Higher-quality BBs have outperformed Bs and crushed CCCs. (See chart above.) CCC loans were barely positive for the year as of October 4. This is “particularly striking on a beta-adjusted basis,” according to Hart. Usually, you’d expect CCCs to move up along with equities, but that hasn’t happened. Hart says credit investors are not rewarding aggressive issuer behavior. Hart says BB bonds are more rate-sensitive, so their outperformance could be related to rate expectations in addition to an increasing quality bias.
Credit Market and Macro Fundamentals
Charts courtesy of Alcentra/BNY Mellon.
Alcentra is more worried about volatility stemming from late-cycle investor behavior rather than the fundamentals of the issuers in their portfolio. Despite retail investor fears, the average corporate borrower is in good shape. In the loan market, Hart says there are few parallels to borrower characteristics before the 2008 financial crisis:
- Earnings for loan issuers are surprising on the upside overall. Looking at manufacturing PMIs a month or so prior, you may not have expected that.
- Loan leverage is low at around 5.5x. This level is below the long-term average of 6x. Though it’s hard to miss the increase in the second quarter of 2019. Leverage was at similarly low levels and rising in 2007.
- Interest coverage is high. Due to low interest rates, interest coverage is near the highest level it’s been, looking back to 2001 (greater than 4x vs. a historical average just under 3.5x). This metric is harder to argue with. It’s difficult to see LIBOR jumping near term to levels that would reduce interest coverage to even the long-term average, let alone to the lower-than-3x levels seen in late 2007.
- Asset coverage is right at the historical average. However, this metric is exceptionally stable from year to year and has rarely deviated from the average even through the 2008 financial crisis. But it’s interesting that despite the increased leverage used in leveraged buyout (LBO) deals recently, asset coverage has held fast to average levels.
Turning to consumers, Hart says they are doing well and spending money. Unemployment is low and consumer sentiment is high. Their free cash flow ratio is strong just like for corporations. All this is supportive of loan issuer fundamentals. Within Litman Gregory, we’ve discussed in past internal research meetings that indicators like unemployment, which is a lagging indicator, always look good right before the end of a cycle. On the other hand, that fact can become an easy excuse to dismiss any positive economic data point. At worst, we would say the data is mixed. Outside of CEO/CFO confidence, manufacturing surveys, and a yield curve that is steepening after having inverted, we agree there is support for a continued economic expansion.
Chart courtesy of Alcentra/BNY Mellon.
New loan issuance in 2019 has been modest at $264 billion as of mid-October, much lower than in the last two years.
No Signs of the Apocalypse
Alcentra doesn’t think we are at the end of the cycle yet based on loan market fundamentals and the macro backdrop. What is late-cycle is investor behavior. Hart says a gulf has opened up between what investors are reading about in terms of recession risk and what actually matters to credit markets.
You should see people “doing really risky stuff on the margins.” But this has not materialized according to Hart. High-yield CCC and second lien loan issuance is way behind pre-crisis levels. CCC as a percentage of the high-yield market is down at 11% as of September 30, about the lowest it’s been since 2000. Headline transaction values of LBOs are increasing, but Hart contends that since 2008, investors are putting up more equity and the types of companies being bought out has changed. Where they were once part of the energy-industrial complex, they are now higher-growth, global, tech-related firms deserving of higher multiples. Hart and his team do not see people overreaching.
The bottom line is that Alcentra does not see the risk of widescale defaults in the loan market like in 2009. The price drop back then was further exacerbated by loan investors who had taken on leverage and became forced sellers, which isn’t the case today. Broadly speaking, Hart does not see anything that can hit borrowers to such a degree that they can’t pay their bills. It certainly won’t be rising debt costs. The forward-looking expectations for the short-end and belly of the yield curve is for falling rates. Hart says: “Due to how global trade works, the likelihood of the U.S. being the first one to raise rates is pretty thin.” He doesn’t see us making the U.S. dollar less competitive.
What Is Worth Looking At?
While defaults should remain low, that doesn’t mean loans can’t trade down. There are things worth looking at, which Alcentra is monitoring closely:
- Downgrades are increasing. Downgrade-to-upgrade ratios are rising in both loan and high-yield markets. Ratings migration is partly a consequence of the larger B-rated population, which now makes up over half the loan universe. B-rated securities have historically had higher downgrade rates than BBs.
- Distressed ratios have risen slightly off their lows. The percentage of loans trading below $80 has risen from next to nothing a year or so ago to around 5%.
- Covenant quality has declined. Documentation scores have been falling for years. Much has been made of this point in the financial press. It doesn’t necessarily cause defaults, but it can lead to price downside for issues with light protections.
- EBITDA adjustments are rising. To lower their borrowing costs, some issuers will offer forward-looking “pro forma”-type accounting statements inclusive of some proposed acquisition or business change. This is a ridiculous practice but it is being accepted by the market. Over a third of loan market issues involve an EBITDA adjustment now, up from the teens a few years ago.
Hart says how these factors develop will drive loan price performance.
The True Bear Case for Loans
Rising debt costs alone will not hit loan issuers. If rates are rising for the right reasons—a strong economy—that is great for borrowers. In fact, the ideal scenario is continued modest GDP growth with slightly higher interest rates from here. In that situation, loan investors collect a larger spread over core bonds without suffering a wave of defaults.
The true bear case for loans, says Hart, is stagflation. (This scenario would hurt most asset classes.) The prospect for such an outcome may seem remote, but President Trump is “trying to undo global trade.” Whatever your politics, Hart says raising the price of goods while utility stays the same is massively inflationary. Inflation destroys corporate earnings at the same time debt costs are rising. One mitigating factor is that if tit-for-tat tariffs get out of hand, and stock markets fall hard, Hart thinks the Federal Reserve and the president would both try to step in with monetary and fiscal policies to fight inflation.
The key is that loan investors are owed par. The gravity of that fact makes five-year return expectations for loans across economic scenarios converge around a central estimate close to the current yield (about 6%). The question is whether this compensates investors for both the default risk and the volatility risk. We agree with Hart that it does.
Loans vs. High-Yield
Chart courtesy of Alcentra/BNY Mellon.
We have often expressed our preference for loans over high-yield. Hart echoed that sentiment during our conversation. From an “investable” yield perspective (removing energy from high-yield), loans yield more than bonds. Plus, they are more secure than the average bond, given loans’ seniority in the capital structure.
More than 80% of the high-yield market currently trades at or slightly above call price. So investors have pulled returns forward in the bond market and now face negative convexity. Even if rates go lower, high-yield is not going to trade materially higher. The exact opposite situation is true in the loan market. B and even BB loans trade below par so there is price appreciation potential, though you don’t need to count on it to beat high-yield, as loans have higher carry.
Our view is that continued high-yield outperformance over loans is predicated upon a very narrow Goldilocks scenario in which the Fed keeps rates low or even cuts further to extend the cycle, while avoiding both recession and strong reflation. Because in a recession bear market, loans should hold up better than high-yield, being higher in the capital structure. And in a sustained cyclical rebound, rates should rise. Loan issuers would benefit from improving fundamentals, while loan investors would benefit from rising coupons. High-yield prices, on the other hand, have duration risk. One has to wonder why the Fed would keep rates this low for an extended period of time (or cut more) if nothing bad is on the horizon.
Chart courtesy of Alcentra/BNY Mellon.
Fund Positioning & Performance
The fund has underperformed the leveraged loan index recently. The culprit has been Alcentra’s overweight to B-rated loans, which kept them from fully participating in the up-in-quality dynamic this year. They think the B-rated segment is where they can be most efficient with investor capital and capture the best risk-adjusted return in the loan market. Hart says: “Investors will pay any price for BBs. And there can be no price an investor would pay for CCCs—anything can happen.”
For them, quality needs to be set against valuation. In their opinion, BBs are a bit overbid. A lot of the BB market is now call-constrained and can be repriced overnight. There’s not much more juice left in that rating segment. Meanwhile, Bs have a 200-basis-point yield advantage over BBs, as they trade much farther below par.
Alcentra’s focus remains on owning the right names and “quadrupling down” on what they own. They are confident in the issuers they own. They believe their portfolio is higher quality than the index on a name-by-name basis, irrespective of official credit ratings. Plus, they have a decent carry compared to peers. They are positioned for a carry game and are not expecting prices to trade up. In an environment like that, your coupon is your hedge. That said, they have been marginally reducing their BB underweight over the last year.
Litman Gregory Opinion
As we discussed in our original due diligence on BNY Mellon Floating Rate Income back in August 2018, our long history with Hart and our conversations with the Alcentra investment team gave us the high level of confidence to invest in the fund. We continue to expect the fund to outperform the S&P/LSTA Leveraged Loan Index over a full market cycle.
We remind investors that there is only a very short track record with which to evaluate the fund as it is currently managed. Portfolio manager Kevin Cronk only took the helm in late May 2017. Also, important changes were made to the fund in June 2018 (including removing an elevated required cash component) that make performance prior to that less relevant.
Performance during our holding period has been disappointing relative to the index and the other loan fund we own, but the thesis behind Alcentra’s overweight to Bs vs. BBs makes sense in our eyes. We recognize credit ratings are lagging indicators, and what matters most is the fundamental, bottom-up work Alcentra’s team conducts that goes beyond a simple letter grade to gain a thorough understanding of the issues they own. We continue to think Alcentra can outperform the broader loan market through winning by not losing on the back of their active credit selection. BNY Mellon Floating Rate Income remains an Approved option in the Floating-Rate Loan category. And the combination of higher yields/lower prices (loans are trading a few points below par), and being senior in the capital structure, make loans a more attractive asset class in our opinion, both in absolute terms and relative to high-yield bonds over a five-year investment horizon.
—Eric Russell Figueroa, CFP®, and Jack Chee