Loans Views—Q1 2021

    Franklin Templeton Fixed Income

    As we anticipated, volatility increased in the loan market over the fall, with spreads tightening from August through mid-September, widening into October, then rallying post-election. Loan market technical conditions remain generally supportive, driven by continued strong demand from collateralized loan obligations (CLOs), a tapering of retail outflows and a moderate new-issue supply calendar. Defaults have continued to tick higher, but the pace has moderated, and negative rating actions have seemingly reached an inflection point. Fundamentals appear to be recovering and much of the potential distress has been priced in.

    Over the medium to long term, we are constructive in our outlook on the loan market. The results of the US presidential election and a US Senate race that has largely concluded without one-party dominance could help alleviate market uncertainty as investors now have a better expectation of policy direction. The prospect of sweeping health care regulations and of more actionable scrutiny of the technology sector carries lower probability than we feared prior to the election, which, broadly speaking, bodes well for performance in these sectors.

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    Visit Global Fixed Income Macroeconomic & Sector Views: Q1 2021 to learn more about our outlook for each sector.

    Pfizer/BioNTech and Moderna’s positive COVID-19 vaccine results set an optimistic tone for other vaccines in advanced stages of clinical trial, which are providing tailwinds for market sentiment, leading to tighter spreads. We are optimistic that the market headwinds of 2020 will gradually subside throughout 2021. At this point, we feel comfortable reducing Upper-Tier loan exposure and increasing Middle-Tier exposure. While focused on fundamentally sound credits in the immediate term, we are looking to position for longer-term recovery. However, in the very immediate term, COVID-19-related challenges persist, with rapidly rising case counts in the winter months, which could prompt periods of volatility. We are watching industry sectors with material exposure to COVID-19 disruption and are maintaining a highly selective stance toward credits in these sectors. We are selectively adding single B tranches and are staying nimble about relative value between the primary and secondary market.

    Taking a closer look at the election results, we anticipate greater legislative and regulatory change following an election where Democrats have taken the presidency and maintained control of the House of Representatives; however, the extent of changes will ultimately depend on control of the Senate. In the event Democrats win both US Senate seats in Georgia in the upcoming runoff election, the prospect for legislative changes increases, but the deciding votes will be held by the most conservative Democratic members and any progressive legislation is likely to be tempered. If Republicans win one or both Georgia Senate seats and retain control of the chamber, we expect few areas of compromise with the Democratic administration. The proposition of higher tax rates is seemingly off the table for now, which is certainly a positive for the loan market. Still to be determined is the impact from the changeover in interest deductibility moving to EBIT from EBITDA. Asset-heavy industries will be most impacted, and to the extent they are cyclical, it is possible that there is a revision on this part of the tax code to protect the ongoing economic recovery. Finally, we had assumed there would be a larger immediate-term stimulus with larger infrastructure spending, which would have been supportive of the loan market, but a split government tempers these expectations. This is certainly less positive than we had hoped, but we do believe there will be additional support forthcoming.

    Meaningful new issuance has come to the market in recent months, including leveraged buyout (LBO) deals. Institutional loan volume tied to LBO deals rose to $9.5 billion in October, driven in part by sponsor-to-sponsor transactions, the second highest monthly total since $10.8 billion in January 2020. Despite the rebound, LBO volume still lags 2019, as a significant portion of this year’s volume remains repricing, and refinancing transactions from the beginning of the year. As LIBOR has continued to fall further, more loans in the primary market have had to come with floors. In October, 85% of new issue loans came with a floor, with an average floor of 85 basis points.

    Approximately 38% of the market now has a floor above 0%. We anticipate loan issuance to increase in the next year, driven by a rebound in refinancing and merger & acquisition deals. As the market continues to recover, we expect issuers with higher spreads to be able to refinance, but repricing activity is likely to be lower than previous periods, as only 9.5% of the market currently trades above par, compared to more than 59% of the market at the end of 2016 and 56% at the end of 2017. Furthermore, with a major tax overhaul unlikely, an economic recovery should help to support a return of deals to finance acquisitions.

    We previously had a modestly bearish outlook on loans, given the volatility we were expecting over the fall. We wanted to wait and see how defaults and downgrades evolved, whether loan issuers started bringing back clearer guidance, how the election played out, and whether there would be further progress on a timeline for a COVID-19 vaccine. Since then, the pace of defaults and downgrades has moderated, the election uncertainty is substantially resolved, we have received positive news on the vaccine front, and performance by issuers has exceeded expectations. We believe we have gone through the trough of the recession, and by several measures, are on the path to a recovery. Given how the loan investor base continues to evolve and how spreads have performed, despite fundamentals still not having caught up with technicals, our expectations over the next 12 months are that while we may see air pockets in the interim, loans will see sustained spread tightening over the next several months. However, this tightening will not be driven by large retail inflows on the back of rising LIBOR, though we believe retail outflows should be muted going forward and rate expectations are rising, given record low levels currently.

    Progress on the vaccine should also limit trigger-happy downgrade action by the rating agencies and provide more rating breathing room to loan issuers. Spread tightening will be driven by very few positively yielding fixed income alternatives for investors, globally. This will be in the form of separately managed accounts (SMAs) as well as continued healthy CLO formation. We will also see investors that play in both HY and loans continue to toggle between the two based on technical conditions and relative value in the two markets, which should keep spread differential in these two markets contained. Relative value investors may also value the lower historical volatility in loans combined with senior secured status, which should provide protection in a risk-off environment. At the same time, in a risk-on environment, investors would benefit from any rise in rate expectations by being in loans. Further, given that average prices of loans are still well below par, repricing risk is muted for the foreseeable future.

    We would be remiss if we did not strike a note of caution on our confidence around the directionality and magnitude of spread movement in the near term due to the uncertain course of the virus over the potentially dangerous winter months fueled by holiday travel. There will likely be periods of risk off in the next couple of months driven by rising COVID-19 cases, providing opportunities to add to loans from fundamentally sound issuers at attractive levels. Given the constructive pivot in our view over the next 12 months, we’ve upgraded our outlook to neutral with reasons for optimism, given that conditions are aligned for further spread tightening from here given the changes in the investor base, lack of many positively yielding fixed income alternatives, and a cyclical upswing over the coming quarters.


    WHAT ARE THE RISKS?

    All investments involve risks, including possible loss of principal. Municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. The price and yield of a MBS will be affected by interest rate movements and mortgage prepayments. During periods of declining interest rates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore MBS investors may be forced to reinvest returned principal at lower interest rates, reducing income. A MBS may be affected by borrowers that fail to make interest payments and repay principal when due. Changes in the financial strength of a MBS or in a MBS’s credit rating may affect its value. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields reflect the higher credit risks associated with certain lower-rated securities held in the portfolio. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy.

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