Kames’ Holmes warns on ‘investor darling’ leveraged loans
Investors who have piled into leveraged loans in 2017 could be caught out by the rate-hiking cycle in the US, with the bonds likely to lag other parts of the fixed income market, Kames Capital’s Jack Holmes warns.
Holmes, support manager on the recently launched Kames Short Dated High Yield Global Bond fund, says investors who have purchased the loans for their relative protection against higher borrowing costs could be in for a nasty surprise.
“Investors have sought out leveraged loans as a place to hide from a Fed that is raising interest rates, and with the perception that they are a “safer” income provider than conventional bonds,” he says.
“They have become something of an investor darling this year, but the logic is flawed. US leveraged loans underperformed US high yield by almost 2% per annum over the 2004-2006 hiking cycle. In a hiking cycle, high yield bonds tend to perform well due to their positive exposure to economic growth, while loans offer far less opportunity for capital appreciation.”
Some $13bn has flowed into US loans year-to-date, with investors seeking to protect against the so-called reflation trade which US President Donald Trump’s policies may – or may not – spark via his various economic policies.
However, as well as failing to match returns made by high yield during a rate-hiking cycle, Holmes warns the loans offer little by way of additional protection in the event of a downturn for the economy and markets.
“The peak-to-trough drawdown was 95% of that seen in high yield during the financial crisis, while high yield has produced 127% more total return over the last 15 years,” Holmes says.
“In other words, investment in leveraged loans over the past decade and a half has resulted in almost as much drawdown while sacrificing the large profits that could have been made by a long-term investment in high yield.
“Leveraged loans are also more exposed to problem sectors than high yield. Retailers that are mortally threatened by Amazon make up more of the investable universe in loans than in the high yield universe,” he says.
The situation in Europe is similarly challenged. “Leveraged loans are getting riskier – in Europe the average secured indebtedness for new loans is almost 70% higher than at the end of 2010. In contrast, European high yield leverage has actually fallen over this period,” he adds.
Rather than run such risks, Holmes says investors are better served via high yield bonds.
“A well-managed high yield portfolio provides a much better way to generate strong sustainable income versus alternatives such as loans. By investing with high yield teams focused on finding defensively-positioned companies with strong business models, attractive risk-adjusted total returns can be generated.”