Joseph Welsh, CFA Senior Vice President, Portfolio Manager Head of the High Yield Corporate Debt Team OFI GLobal Asset Managers
P&I: How long has the firm been investing in floating-rate loans?
Joseph Welsh: We started investing in the loan category in 1997, and we launched our flagship fund, the Oppenheimer Senior Floating Rate Fund in 1999. We have an incredibly cohesive and stable team that has grown over the years and has remained largely intact since inception. Our decision-making uses a fundamental bottom-up process, and every loan that goes into the portfolio gets there because one of our analysts understands the company, the loan structure, the collateral, and covenants. Additionally, we believe that each loan in our portfolio provides good relative value versus other choices in the market.
P&I: What are the potential benefits of senior loans to investors?
Joseph Welsh: In my opinion, the main benefits of senior loans versus competing asset classes are their historically high levels of income relative to other fixed income choices and their very low duration or interest rate risk. Loans are also good diversifiers—they have very low correlations with most other fixed income categories, and they can help to improve overall risk-adjusted returns for a diversified portfolio.
P&I: Is this a good time to invest in loans?
Joseph Welsh: I won't say it's just a good time to invest in loans—it's an outstanding time. Typically, the floating-rate loan category is one of the best, if not the best, fixed income categories during a period of rising rates. And right now, the general trend in interest rates for the next three to five years will be up in my view. Should Fed tapering be delayed by a quarter or two, senior loans may still provide considerable income pick-up over most fixed income categories.
We encourage our clients to think of loans as an integral part of their overall fixed income allocations not simply as a subset of high yield. I recommend comparing the features and benefits of senior loans against all other traditional fixed income investments: core and intermediate term investment grade bond funds, Treasuries, munis and other fixed-rate, long duration categories. I view loans as superior when I run my own comparisons given the current market environment. The investment-grade core bond category, for instance, still has lower yields than loans can provide, and the Barclays Aggregate Bond index has substantially longer duration than loans. So we think it's going to be tough for traditional longer-duration, lower-yielding strategies to produce competitive total returns if the market enters an extended period of rising interest rates.
P&I: The loan market is robust right now. What's driving it, and what are the risks?
Joseph Welsh: Fixed income investors are recognizing the benefits that loans provide in this new environment of rising interest rates. We have been through a very long period of rate declines, and investors have always assumed that investment-grade bonds were safe. But that assumption refers only to credit risk and ignores the duration risk we now face.
All fixed income investments have at least two significant sources of risk. One is credit risk, and the other is interest rate risk. With respect to interest rate risk, Treasuries and other long-duration, high-credit quality, fixed income products are certainly not safe. They're among the riskiest debt you can buy. So, if you're just talking about interest rate risk, you could consider Treasuries to be “junk bonds”, or you could consider investment-grade core bonds as “junk”, because they have significant interest rate risk. True, Treasuries and investment-grade bonds have less credit risk than loans do, but we view the amount of credit risk in the market as fairly muted in the near-term. Default rates have been below 2% for the past several years and are projected to continue to be low for the next several years. See Chart 1 - “Defaults are Projected to Stay Low”.
Investors need to mentally decouple credit risk and interest-rate risk in my view. For too long, fixed income investors have commingled the two. The conventional view is that investment grade–rated debt is safe and below–investment grade rated debt is not. But given the current market conditions that concept should be flipped on its head. With respect to interest-rate risk, senior-secured floating-rate corporate loans may be “safer” than most realize, and long-duration investment-grade bonds may be more risky than most appreciate.
The conventional thinking about what is safe and what is risky in fixed income is just a function of Treasury rates over the past thirty years. They've trended straight down. But now that rates are going the other way it really changes the story. We're going through a true inflection point in the fixed income world right now. Those bond funds, once considered safe, are down over 2% year-to-date. As rates continue to rise, that type of return experience will prevail. Investors will have to get used to that.
P&I: Are you concerned about the trend toward covenant-lite (cov-lite) credit agreements?
Joseph Welsh: It's a complicated and misunderstood topic. The long and the short of it is cov-lite is a trend that's definitely happening. The financial press and others who are negative on this asset class point to cov-lite a lot. But it's really not nearly as big of a deal as some make it sound.
One has to study the entire covenant package of a given loan to make a comprehensive assessment of the credit risks involved. One shouldn't just pluck one feature out of a covenant package and determine if that credit agreement is good or not. There are plenty of traditional covenant packages (the opposite of cov-lite) that are terrible. For example, they might allow for a very high leverage ratio with weak controls on restricted payments. And all cov-lite packages are not necessarily bad, and there are many instances when a cov- lite package is better overall than a package with traditional covenants.
Consider the following examples. Which is a better credit risk? A cov-lite deal that has a debt limit of five times (meaning you can't incur any more debt over five times your trailing twelve month EBITDA) or a traditional maintenance covenant that would allow the company to lever up to ten times? I would rather have a debt limit of five times rather than tripping a maintenance covenant when leverage reached ten times. That's a big difference. There are also cov-lite deals that are secured by separable and saleable collateral that could be worth twice the loan amount, or you could have traditional maintenance covenant deals that are totally unsecured. So which is better? I'd go with the secured deal. If you're secured by collateral worth over two times the value of your loan, that's really good. So you can't just say that one covenant type is bad and one is good. You have to look at all the details of the whole loan package, and simplistic labels such as cov-lite versus traditional covenants do not tell the whole story.
P&I: How do you handle sector weighting?
Joseph Welsh: I meet with our analysts regularly to discuss the outlook for their sectors. Besides me, we have nine people who track industries, follow companies and study credits. We discuss the outlooks for the various sectors, the types of risks going on and what type of yields are available. We overweight those sectors that have little projected risk and that also pay the highest level of interest relative to that risk.
P&I: Describe your pure play approach.
Joseph Welsh: The most common way to deviate from pure play in the loan category is for managers to spice up their loan funds with fixed-rate high-yield bonds. I think, on average, it's common for managers to add about 10% in high yield bonds to their loan strategies. In our flagship strategy, we don't do that. Adding bonds may increase the yield, but it also increases duration and reduces potential recovery rates if those bonds get into trouble. It's not a terrible thing to do, but it creates a different risk profile that investors should be aware of. In fact, we just introduced a strategy that includes high yield and financial leverage for those investors that want that, but you do need to be clear about what your product is. Most clients want to allocate assets on their own, and if they buy a loan strategy from somebody, they want to know that it really is comprised of senior loans.
P&I: How did loans perform during the financial crisis?
Joseph Welsh: The only negative year of the past 20 in the loan category was 2008. And the markdown was significant. See Chart 2 - “Historical Annual Returns of Senior Loans”w. It was just under 29% negative. But 2008 really wasn't a loan market phenomenon or a loan market specific problem. We saw a global liquidity crisis in 2008. No one had money to buy anything with any credit risk whatsoever. Everyone was getting redemptions and investors were shell-shocked. People had to sell a variety of asset classes and high yield was down substantially as well—about 26% or so. Equities, of course, were down. A lot of commodity funds were down. But in 2009, the loan market came roaring back as the liquidity crisis subsided, Returns in the loan market were roughly positive 45% in 2009. So over that two-year period, 2008 and 2009, the loan market had positive returns on average. Should a global liquidity crisis happen again, investors in this category should look to the long term and understand that these loans are senior and typically secured obligations of a lot of big companies across the country. I believe that it's unlikely that losses of 2008's magnitude would be sustained for a long time.
Another big lesson from the crisis is not necessarily what investors learned—it's what loan issuing companies learned. The issuing companies that had the most trouble during the liquidity crisis of 2008 were those that had debt maturing, or amortizing, in the very near term. A lot of companies prior to the crisis assumed that capital markets would always be open for them, and there would be no troubles. So they weren't really concerned about a big bond or loan issue maturing shortly. They always felt confident—or cocky—that they could refinance whenever they needed to. But that certainly wasn't the case during the fourth quarter of 2008 or the first quarter of 2009. Capital markets were really shut down, so a lot of those companies that had big amortizations during that period went bankrupt, and default rates shot up to about 10%. When the crisis was over by April of 2009, just about all of the surviving issuers went straight out to the market to extend their maturities. No company really wants to have a big amortization looming over its head, because you never know if market sentiment will hinder refinancing potential. Issuer's efforts toward extending their debt maturities is one of the big reasons why default rate projections for the market are below 2% going forward. Another reason is the big cash balances that companies keep these days. We believe these changes make our loans a little bit safer from a credit perspective.
Joseph Welsh: OFI Global Asset Management (“OFI Global”) consists of Oppenheimer Funds, Inc. and certain of its advisory subsidiaries, including OFI Global Asset Management, Inc., OFI Global Institutional Inc., OFI SteelPath Inc. and OFI Global Trust Company. The firm offers a full range of investment solutions across equity, fixed income and alternative asset classes. These views herein represent the opinions of OFI Global Asset Management (“OFI Global”) and are not intended as investment advice or to predict or depict the performance of any investment. Our investment strategies may be offered through various investment products that are advised or managed by one or more investment advisory entities comprising OFI Global. Special Risks: Portfolio investments are subject to market risk and volatility.
These views are as of September 1, 2013 and are subject to change based on subsequent developments. OFI Global disclaims any responsibility to update such views. No forecasts can be guaranteed. The material contained herein is not intended to provide, and should not be relied on for, investment, accounting, legal or tax advice. Further, this material does not constitute a recommendation to buy, sell or hold any security. No offer or solicitation for the sale of any security or financial instrument is made hereby.
OFI Global is a GIPS firm that includes the assets managed or advised by OppenheimerFunds, Inc. (“OFI”) and each of its advisory subsidiaries, with the exception of pooled investment vehicles that invest in collateralized debt and loan obligations, non-master limited partnership wrap program assets and legacy non-U.S. domiciled pooled investment vehicles managed by such advisory subsidiaries. The firm offers a full range of investment solutions across equity, fixed income and alternative asset classes. OFI Global personnel who provide advisory, trading, and other services may be employed by or associated with OFI and/or affiliated entities.
OFI Global's Senior Loans Composite includes every fully representative portfolio managed in the strategy. The strategy invests in senior bank loans, which are primarily lower rated (below investment grade) securities that adjust their interest payments periodically based on changes in interest rates. Securities holdings can be selected regardless of a security's membership in the benchmark index. Certain securities may constitute a significant portion of the portfolio resulting in security and sector weightings that may differ from those of the benchmark index. The composite was created in April 2013.
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