Why bank loans look attractive in today’s market

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By Reema Agarwal, CFA, Director, Floating Rate Debt, Franklin Templeton Fixed Income

The technical and fundamental situation appears 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 in what is likely to be a period of tight monetary policy during the year, and periods of volatility should be seen as buying opportunities.

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

With the exception of a brief hiatus around the discovery of the Omicron COVID-19 variant, credit spreads have continued to tighten steadily, especially since mid-September, when expectations regarding the narrowing of the US Federal Reserve and rate hikes began to escalate, which provided favorable winds to the floating rate bank lending industry. Technical conditions remain sound: record guaranteed loan bond (CLO) issuance and retail demand have supported loan prices. While there may be a lull in loan market activity in early 2022, as market participants absorb the implications of the transition from the London Interbank Offered Rate (LIBOR) to the guaranteed overnight rate. On the day (SOFR), we believe that CLOs will continue to be an attractive option for investors, which supports loan valuations and provides a floor on loan prices. Overall, retail flows have been consistently positive in 2021, driven by expectations of higher interest rates.1 We believe current credit spreads are attractive and technical conditions remain in favor of a tightening path. We also believe that expectations about when an interest rate takeoff 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 work, 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 and recreation emitters such as gymnasiums 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 building materials was strong, but margins were negatively affected 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, but with a lag. Issuers of consumer, retail and food products have also faced higher input costs and labor inflation, with varying capacities to pass price increases.

On the other hand, some issuers take advantage of it. Commodity issuers are clearly profiting from inflation, and loan prices increased the most in these sectors in 2021, although it should be noted that these sectors only represent 5% of the loan market. We are aware of the cyclical recoveries that could run out of steam for some sectors that had thrived during the pandemic. At the same time, we are looking for loan issuers whose business models are likely to benefit the most from the permanent changes in consumption patterns / behaviors 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 rate hikes, or potential macroeconomic challenges posed by the Omicron variant, on a selective basis we would consider these periods as buying opportunities, because we believe that business fundamentals are still healthy.

In general, we favor loans rated B, especially those with LIBOR floors. As the probability of an increase in prices and interest rates is higher than it has been in recent years, we maintain our opinion that industries whose fundamentals are questioned could be more affected. than others, especially those with a struggling supply chain. Amid the idiosyncratic risk of issuers, careful stock selection remains paramount, 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 derail, the full recovery. We also don’t expect a high probability of large-scale fundamental weakness in the lending market over the next year, particularly to such a degree that it overshadows important technical tailwinds for fixed income assets. variable. We maintain our positive outlook for the bank lending sector: over the next 12 months, technical conditions should remain strong and fundamentals broadly positive with moderate default rates, against a backdrop of 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 the prices of the bonds in an investment portfolio adjust to an increase in interest rates, the value of the portfolio may fall. Investments in lower rated bonds carry a higher risk of default and loss of principal. There are special risks associated with foreign investments, including currency fluctuations, economic instability and political developments. Investing in emerging markets involves increased risks associated with 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 the investment grade. Investing in higher yielding variable rate loans and debt securities involves a higher risk of default, which could result in a loss of capital, a risk that may be heightened in a slowing economy. The interest received on variable rate loans varies according to the evolution of the interest rates in force. Therefore, although variable rate loans provide 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 can affect its value.

1. Sources: Franklin Templeton Fixed Income Research, JP Morgan. As of October 2021. There can be no assurance that an estimate, forecast or projection will materialize.

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Editor’s Note: The bullet points for this article were chosen by the editors of Seeking Alpha.

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