Hungry for Yield? Loans May Satisfy

Point of View With Leland Hart

It's a question baffling many a fixed income investor today: "How can I enhance yield in my portfolio without appreciably increasing risk?" This musing of the income-hungry, risk-aware investor is fairly easily addressed, according to BlackRock's Leland Hart. The answer? Floating rate loans.

• Attractive relative yields. Loan yields today are compelling versus most other fixed income, including high yield bonds. In fact, the two are offering comparable yields.
• Protection from rising rates. Because loans are floating rate, they present negligible interest rate risk. Investors do not have to sacrifice yield in order to lower their duration risk.
• Muted credit risk. In general, companies that issue loans are in sound financial shape and, as a result, default rates are near historic lows.
• Enhanced diversification. Loans demonstrate a historically low correlation to US investment grade-rated bonds and Treasuries, making them good portfolio diversifiers.

What makes loans attractive currently?

Loans offer a compelling yield versus most other fixed income alternatives today. In fact, loans currently offer yields comparable to those of high yield bonds, something we've seen only on rare occasions. You're essentially able to capture yields very similar to those offered by high yield bonds, but with the benefits of lower volatility, a floating rate coupon and claim at the highest rung of a company's capital structure.

So that's special and unique today, but it's always the case that loans are floating rate instruments and, as such, have an effective duration of zero. When interest rates rise, the total coupon of a loan increases, which prevents the instrument from losing value. This sets loans apart from other fixed income assets, which have duration and can experience price declines with a rise in interest rates. So loans offer a relatively high yield, but they do not require investors to take interest rate (or duration) risk.

Also compelling is the fact that investors in loans today are being very well compensated for the amount of credit risk they are taking, for two key reasons. First, because loans are the highest rung of a company's capital structure, they are the first instruments to be repaid, can prevent the company from prepaying any other creditor before them and are protected by a claim on all of the company's assets in case they are not paid. Second, credit indicators for the companies in which we invest remain strong, and this should bode well for credit-sensitive fixed income assets. This rather benign credit environment appears likely to persist for the next couple of years. So with the average loan offering a yield to maturity of approximately 5.5%, we think investors are being well compensated for the low level of risk in credit today.

What do loans bring to a broader portfolio?

Loans are traditionally a relatively low-volatility asset with a negative correlation to high-quality bonds, which makes them a great diversifier. A lot of our clients use loans to add income and diversification to portfolios with lower volatility targets. Loans also have a quality appeal—they are essentially a higher-quality source of income, historically offering strong downside protection. Consider that the historic recovery rate on high yield bonds has been about 40 cents versus about 80 cents on the dollar for loans. Loans have higher recoveries because of the secured nature of the collateral package. That means in any bankruptcy, loan investors are the first to receive payout on the liquidation or restructuring of those assets. In our portfolios, we think of loans as a proxy for long-dated investment-grade corporates and high yield as a proxy for the equity market.

How do you assess loans vs. high yield bonds?

We strive to identify the best investment opportunities within capital structures, seeking to increase seniority and reduce duration without giving up an excessive amount of yield. One factor we consider is the yield differential between similarly rated bank loans and high yield bonds. Relative to high yield bonds, bank loans offer seniority in the capital structure, stronger covenants and decreased sensitivity to interest rates. As a result of these protections, investors have traditionally accepted lower yields from loans. Currently, however, investors do not have to trade these benefits for yield and are able to invest in loans at yields similar to high yield bonds.

Know What You Own Common Characteristics of Loans and High Yield Bonds
Bank Loans	High Yield Bonds
Senior-most obligation	Senior or subordinate obligation
Secured by all operating and other critical assets	Generally unsecured
Maintenance test convenants	Lightly covenanted
Higher recovery rates	Lower recovery rates
Floating rate	Fixed rate
Average life of 3 years or lesss	Average life of 8 years or more
Lower price volatility	Higher price volatility
Less liquid	More liquid

How would you expect loans to fare in a persistently slow growth economy?

Slow, but positive, growth is great for corporate debt. You have to remember, as lenders, all we really want is to get paid back. We're not taking equity risk, nor do we expect to get paid like equities. In a period of slow earnings growth, equities may not prosper, but credit investors are still paid their coupons. Even in the current low-growth environment, we expect that the companies we lend to—the companies that make up our portfolio—are going to be able to pay us back whether GDP growth is 0%, 2% or 4%.

How have loans performed historically in times of recovery or periods of rising rates?

Let me be clear that we don't see this as a near-term scenario. However, growth will pick up and rates will rise eventually. That said, loans have indeed performed quite well in times of economic recovery, largely because risk premiums decline as the credit environment improves and loans' floating rate coupons rise when the Fed raises short-term interest rates. Loans also tend to protect capital relatively well when things are going in the opposite direction, simply because they are first in line in a company's capital structure—they're senior and secured by all or a part of a company's assets. So, loans do comparatively well in either market because you're taking less risk than other assets, such as unsecured bonds and equity. In fact, over the past 20 years, loans have performed relatively well in every economic environment.

It is in the part of the cycle when the Fed is tightening and interest rates are rising that loans actually tend to outperform most other sectors of the fixed income market. If you look at the last three Fed tightening cycles, bank loans tended to do much better than higher-quality fixed income.

Many investors tend to target the highest yields. Is there danger in that?

Within either asset class, whether loans or high yield bonds, there are higher-yielding assets and lower-yielding assets. Here at BlackRock, we acknowledge the fact that loans can be prepaid at par at any time (unlike many bonds, which have call protection). In fact, most of the higher-quality and liquid loans today are trading at par. As such, you don't have a great deal of price upside. Realistically, all you can do by stretching for the highest-yielding loan is increase your chance of losing money. We tend to avoid those deals that pay just an incrementally higher return for materially more risk. There is no meaningful upside in terms of repayment; all this riskier paper offers is a slightly higher coupon. To illustrate, assume the average loan today pays 5% and a riskier one pays 7%. You might get paid 7% for a year or two, but should that riskier loan default, you may not recover all of your principal and, as such, that higher coupon in no way compensated you for your loss. We much prefer the near assurance of the 5%, rather than risk a loss on the loan yielding 7%. Over time, this approach has allowed us to avoid a great deal of volatility versus the broader market without sacrificing return.

We focus on lending to companies that we have a high degree of certainty will pay us back so that we're assured return of principal as well as a very attractive yield.

So, you're not chasing yield. What do you look for in choosing investments for your portfolio?

We're not simply buying yield. We're buying certainty of income. We're focused on getting our principal back first and foremost, and making money on it second. Loans aren't equity, loans aren't even high yield. Loans are safety first.

Our approach is grounded in intensive credit research and risk management, and is highly intuitive. Our portfolio managers work closely with our more than 20 research, risk and sector analysts based in New York, London and Singapore in a process that involves in-depth analysis and constant questioning. We look at each company, its ability to pay us back and the strength of its management team. We also size up that company within its own industry to determine whether we should own Company X or Company Y. We may even ask whether we should be in that industry at all. Each and every day we sit as a group trying to discern where we can achieve the most value.

While on the topic of risk, what is the outlook for defaults and recoveries in the loan market?

The outlook remains constructive. Over the next two to three years, we project the default rate for loans to be roughly half the average recorded over the last 20 years (the 20-year average being approximately 4%). Currently, defaults are at 1.3%. In addition, a recent study by Moody's found that recoveries over the past 20 years averaged about 80% and, in fact, did not deviate from that in the past three market downturns.

Impressive Recovery Rates for Loans Recovery Experience of Loans Markedly Better Than Unsecured Bonds and Junior Debt
		Previous Default Cycles
	1988 to 1Q 2011	4Q 2008 to 1Q 2011	1990 to 1991	2001 to 2002
Loans	80.3%	77.2%	86.2%	77.9%
Senior Unsecured Bonds	45.7%	42.6%	63.4%	39.9%
Subordinated Debt*	28.5%	27.6%	22.4%	19.3%
Source: Moody's. * Includes senior subordinated, subordinated and junior subordinated bonds.

What can we expect from loans in 2013?

Investors continue to require income-generating investments, and in today's low-interest-rate environment, their options are limited. We believe the hunger for income and dearth of options to satiate it will stoke interest in loans, particularly as investors acknowledge the attractive features we just outlined here. In addition, whereas high yield bonds captured $30.9 billion in fund flows in 2012, loans attracted only $11.6 billion in assets. We think flows could start to favor loans given their attractive relative value. Many of our institutional-type clients that we consider first movers have begun to allocate to the loan space, and we believe this trend will continue.

What role should loans play in a portfolio?

Loans tend to be the focus of attention amid fear of rising interest rates. More recently, however, we've seen many more investors incorporate loans into their portfolios to add another layer of diversity to their income streams. Through loans, they're able to achieve that diversification without having to take duration risk and without giving up current yield. (Diversification does not guarantee a profit or protect against loss in declining markets, but it has been shown to help manage overall portfolio risk.)

How should investors look to fund their investment in loans?

A majority of the flows into loans today appear to be coming from two areas. The first is simply cash, and this is because, with short-term interest rates near 0%, the opportunity cost of not investing has never been higher. Like cash, loans have a duration of zero, so with the yield curve as low as it is in the short end, sitting in cash, CDs or money markets is incredibly expensive. Second, we're seeing investors redeploy assets from higher-quality, longer-duration assets that have a limited credit spread component and, therefore, are more sensitive to movements in the Treasury curve. Loans are a great alternative for these investors.

How can investors access the loan market?

The bank loan market is limited to institutional investors and, therefore, individual investors cannot access it on their own. There are also important risks to consider. The market for corporate loans may be subject to irregular trading activity, wide bid/ask spreads and extended trade settlement periods. We would also point out that investing in companies rated below investment grade requires in-depth analysis and a focus on diversification. The good news is that all of this is available to individual investors through bank loan mutual funds. BlackRock has managed bank loan funds since 1988. In 2010, we launched the BlackRock Floating Rate Income Fund, and in 2012, we introduced a relatively new innovation in the BlackRock Secured Credit Fund. This portfolio invests primarily in floating rate loans and secured bonds, enhanced with opportunistic positions in unsecured high yield bonds. Given our deep resources and experience in the bank loan space, we believe the funds are an excellent choice for investors looking to access the opportunities in this attractive market.

 

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Bond values fluctuate in price so the value of your investment can go down depending on market conditions. The two main risks related to fixed income investing are interest-rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. Commercial banks and other financial institutions or institutional investors make corporate loans to companies that need capital to grow or restructure. Borrowers generally pay interest on corporate loans at rates that change in response to changes in market interest rates such as the London Interbank Offered Rate ("LIBOR") or the prime rates of US banks. As a result, the value of corporate loan investments is generally less exposed to the adverse effects of shifts in market interest rates than investments that pay a fixed rate of interest. The corporate loans in which each fund invests are usually rated below investment grade. The market for corporate loans may be subject to irregular trading activity, wide bid/ask spreads and extended trade settlement periods. Investments in non-investment-grade debt securities (high-yield or " junk" bonds) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are those of the portfolio manager profiled as of January 17, 2013, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that, in certain respects, may not be consistent with the information contained in this report. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks.

You should consider the investment objectives, risks, charges and expenses of BlackRock Floating Rate Income Fund, BlackRock Secured Credit Portfolio, and any BlackRock mutual fund carefully before investing. The prospectus and, if available, the summary prospectus contain this and other information about the fund, and are available, along with information on other BlackRock funds, by calling 800-882-0052 or from your financial professional. The prospectus and, if available, the summary prospectus should be read carefully before investing.

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