Large institutional investors have started to move from government bonds to areas such as infrastructure debt, mortgages and direct loans. But most professional investors are yet to follow suit.
José Luis Borges, head of institutional portfolios at BPI Gestao de Activos in Lisbon, explains: “We have no allocation, neither do we plan to invest in alternative fixed income. We have strict liquidity requirements and are not very familiar with it.”
A ‘better the devil you know’ approach may be sensible but the long-term risk/return prospects for core fixed-income holdings are so poor that investors need to diversify away from the high interest rate risk that low-yielding government bonds bring.
Loans are probably closest to traditional, listed fixed income.
“Loans as an investment case are quite similar to high-yield bonds but they offer a cleaner credit risk exposure,” says Mikkel Sckerl, portfolio manager of a loans fund at Capital Four AM, a Copenhagen-based boutique asset manager with €10bn in AUM.
"With Libor now above 1%, investors can finally benefit from the floating rate component in loans. Any further increase in Libor would be a net positive" - Omar Gadsby
“The loan maturity is typically six to seven years, which is similar to high-yield bonds but loans don’t have call protection and are typically being repaid after three to four years,” Sckerl says. “Loans typically never trade much above par but are a pure income-clipping instrument. They are not about capital appreciation.”
Since loans are always senior-secured, they have a higher recovery rate than high-yield bonds, of which only about a quarter are senior-secured, but they also come with a coupon that is 150-200bps lower. All this results in direct loans showing a stable return profile with a low correlation to other asset classes.
Sckerl’s fund has an annualised return of 5.47% since inception in December 2014, significantly trailing the average return of a high-yield bond fund over that period. But the risk/return characteristics of his fund are excellent: in the listed bond space, it is hard to find a fund with a Sharpe Ratio above three, as his fund has.
On the upside
Omar Gadsby, head of fixed-income fund selection at Credit Suisse Private Banking, is also a fan of loans. He finds them especially attractive now as US three-month Libor has risen to an eight-year high.
“During the majority of the post-crisis period, Libor has been very low, and to make senior loans attractive to high-yield investors, issuers had to implement Libor floors of 90bps [a minimal interest guarantee].
“With Libor now at 1.04%, investors can finally benefit from the floating rate component. Any further increase in Libor would be a net positive [compared with high-yield bonds, which is a fixed-rate investment].”