Bank Loan Default Cycle May be Different this Time

Focus on the default cycle as a barometer for the bank loan sector and how the sector has changed since the GFC.

All else equal, from a fundamentals perspective, we think the risk of elevated defaults in loans is muted over the next year, given low interest rates, no meaningful maturities and a preponderance of covenant-lite (cov-lite) deals. From a technical perspective as well, we see continued support for the asset class from collateralized loan obligations (CLOs), its largest investor group, which could bring about relative stability to the loan market.

Over time, we expect the default experience to be different than in the past, due to the changes in the rating profile in the loan market, combined with loose documentation. Recoveries could also be lower than historical averages in the low-70% range due to the intersection of a variety of market dynamics that differ in many ways from what we saw before the global financial crisis (GFC).

Balancing the two, we are constructive on loans in the near to medium term. We think periods of volatility will permit investors to add paper below par, and add to risk-adjusted returns, especially compared to other more volatile credit asset classes.

Longer term, we continue to believe that it is prudent to be conservatively positioned in terms of credit quality. At the end of the day, it is the underlying credit quality of an issuer that will determine the probability of investors confronting documentation issues in a downturn.

Contributors

  • Director,Floating Rate Debt Group,Franklin Templeton Fixed Income Group®
  • Director of Research, Floating Rate Debt Group,Franklin Templeton Fixed Income Group®
  • Portfolio Manager, Floating Rate Debt Group,Franklin Templeton Fixed Income Group®

Overall, we believe diversification with a focus on maintaining relative price stability vs. the market in periods of volatility, while producing steady income returns is what will generate industry-leading returns over a period of time. In our opinion, an oversized position is more appropriate in seasoned high credit quality issuers where one expects to maintain relative price stability through cycles.

In this article, we focus on the default cycle as a barometer for the bank loan sector. We start by looking at how the sector has changed since the GFC and what we should focus on today.


WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal. 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. Investments in lower-rated bonds include higher risk of default and loss of principal. Investing in higher-yielding, lower-rated, floating-rate loans and debt securities involves greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy. Interest earned on floating-rate loans varies with changes in prevailing interest rates. Therefore, while floating-rate loans offer higher interest income when interest rates rise, they will also generate less income when interest rates decline. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value.