By Reema Agarwal, CFA, Director, Floating Rate Debt, Franklin Templeton Fixed Income
The technical and fundamental picture looks favorable for bank lending for a number of reasons, according to Reema Agarwal, director of floating rate debt at Franklin Templeton Fixed Income. She says current spreads look attractive amid what will likely be a period of monetary policy tightening over the course of the year, and periods of volatility should be viewed as buying opportunities.
Note: The video below was recorded in December 2021. References to “next year” therefore refer to 2022.
Except for a brief pause around the discovery of the COVID-19 Omicron variant, lending spreads have continued their steady tighter march, more so since mid-September when expectations for the gradual reduction in US Federal Reserve and rate hikes began to pick up, which provided tailwinds for the variable rate bank lending industry. Technical conditions remain sound – record CLO issuance and retail demand have supported loan prices. While there may be a lull in lending market activity in early 2022 as market participants absorb the implications of the transition from the London Interbank Offered Rate (LIBOR) to the overnight funding rate Day Guaranteed (SOFR), we believe CLOs will continue to be an attractive option for investors that supports loan valuations and provides a floor on loan prices. In general, retail flows have been consistently positive in 2021, driven by the expectation of rising interest rates.1 We believe current credit spreads are attractive and technical conditions remain supportive of a tightening path. We also believe that expectations regarding the timing of an interest rate hike will be a key determinant of credit market sentiment.
As expected, the path to a full recovery has been uneven across sectors and issuers as economies fully reopen, based on trends in office versus remote working, security restrictions on indoor and outdoor capacity in various sectors and the final demand for activities and services that have been reopened. Office supply companies were slow to recover, as were some aerospace transmitters and recreational transmitters such as gyms and movie theaters. Supply chain disruptions and inflation in labor and input costs have also been headwinds in some cases. Demand for chemicals, packaging and construction materials was strong, but margins were negatively impacted by higher resin and other input costs and/or higher container rates. Many issuers have been able to impose price increases to offset some or all of the higher costs, albeit with some lag. Consumer goods, retail and food issuers also faced higher input costs and labor inflation, with varying abilities to pass on price increases.
On the other hand, some issuers are taking advantage of it. Commodity issuers are clearly benefiting from inflation and loan prices have been the most bullish in these sectors in 2021, although we note that these industries represent only 5% of the loan market. We are mindful of cyclical upsides that could run out of steam in some sectors that had thrived during the pandemic. At the same time, we are looking for loan originators whose business models are likely to benefit the most from the permanent changes in consumption patterns/behaviours and working habits in a post-COVID-19 world.
If we see volatility due to supply chain issues and cost inflation, changing expectations regarding the timing of rate hikes, or potential macroeconomic challenges posed by the Omicron variant, we will consider selectively these periods as buying opportunities, as we believe the companies fundamentals are still sound.
In general, we favor B-rated loans, especially those with LIBOR floors. As the likelihood of rising prices and interest rates is higher than it has been in recent years, we maintain our view that sectors with distressed fundamentals could be more affected than others, especially those with struggling supply chains. In a context of idiosyncratic issuer risk, prudent security selection remains, in our view, essential.
Despite the potential headwinds that lingering inflationary pressures could bring, we continue to believe that supply chain disruptions and inflation have the potential to delay, but not derail, a full recovery. We also do not expect a high probability of broad-based fundamental weakness in the loan market over the next year, particularly to such a degree that it overshadows significant technical tailwinds for floating rate assets. We maintain our constructive outlook for the bank lending sector – over the next 12 months, technical conditions should remain strong and fundamentals broadly constructive with subdued default rates, amid rising interest rates.
What are the risks ?
All investments involve risk, including possible loss of capital. Bond prices generally move in the opposite direction of interest rates. Thus, as bond prices in an investment portfolio adjust to rising interest rates, the value of the portfolio may decline. Investments in lower rated bonds carry a higher risk of default and loss of principal. Special risks are associated with foreign investment, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve increased risks related to the same factors, in addition to those associated with the smaller size and less liquidity of these markets. Floating rate loans and debt securities tend to be rated below investment grade. Investing in higher yielding, lower rated, variable rate loans and debt securities carries a higher risk of default, which could lead to loss of principal, a risk which may be heightened in a slowing economy. Interest earned on variable rate loans varies with changes in prevailing interest rates. Therefore, although variable rate loans offer higher interest income when interest rates rise, they will also generate less income when interest rates fall. Changes in the financial strength of a bond issuer 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 can be no assurance that any estimate, forecast or projection will occur.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.