An interview with Fidelity's Christine McConnell.
Advisors attending the Morningstar Investment Conference in Chicago this month will be in for treat on the morning of Friday, June 25. Christine McConnell, who launched and still manages the Floating Rate High Income fund
Avoiding an ugly bear market in bonds is at the top of many advisors' minds as clients continue to seek safety in bonds, even in the face of rising interest rates and worrisome defaults. McConnell will join other managers who concentrate in rather small segments of the bond universe, but who excel in those spaces. Her particular expertise is in the floating-rate bank loan capital market.
These loans represent credit extended by banks to highly leveraged corporations. To reduce the risk of lending to corporations with below investment grade ratings, the banks syndicate these loans meaning that they parcel out pieces of the loan to other banks and to institutional investors, such as mutual funds. The mutual funds become direct lenders in these loans. These bank loans are made with a floating interest rate that resets every 30 to 90 days based upon LIBOR plus a spread.
Senior and Secured to Reduce Risk
To reduce the credit risk of these loans, they are usually made on a "senior and secured" basis. Senior means the lender is senior to other creditors of the corporation such as high yield bond holders, subordinated bond holders, and stock holders. Secured refers to the fact that these loans are collateralized with property, equipment, inventory, cash, receivables or a combination of the above.
Further protection comes from the covenants attached to these loans. These covenants either require a company to do certain things or act in a way that protects the lender (affirmative covenants) or prohibit a company from acting in a manner than increases the lender's risk (negative covenants). Common covenants include keeping taxes and business licenses current, maintaining all real and tangible property, maintaining adequate insurance, not taking on additional debt, not selling assets or equipment, not making dividend payments to shareholders, not allowing other liens to be placed on the assets that are collateralizing the original loan.
Small, but Growing Universe
McConnell estimates that the entire asset class of leveraged bank loans is only about $500 billion in size, but increasing. Recent announcements by several of the largest banks reveal that new issuance of these loans has increased by 55% over 2009. In the face of a sell-off in other speculative-grade debt due to the fear of increasing defaults, banks have arranged $1.84 billion of loans, more than twice the high yield junk bond issuance in just one week, according to Bloomberg. JPMorgan reports that banks are currently working to underwrite $16 billion of these high-yield loans compared with only $1.2 billion in bonds.
McConnell says this increase makes sense with the fear of tightening liquidity. Corporate CFOs are looking to stash as much cash as possible while they can still obtain it, even though they may already have significant leverage on the books. "These [floating-rate bank] loans can help them to stockpile the liquidity in case the window closes".
The obvious risk with floating rate bank loans is the credit/default risk. When asked how she selects the loans for her highly rated fund, McConnell emphasized her conservative and tempered approach to this asset class. "I first look at the seniority of the debt. In some situations, every lender is considered senior, in which case it doesn't mean much. I want to clearly be at the top of the heap when it comes to other lenders. Then I look at the security. I am only interested in hard, tangible, tradable, definable assets as collateral. " She also states that she is not so much swayed by a particular brand, since any brand is subject to event risk.
In the case of a default on one of these loans, McConnell says that the quality of the underlying assets will determine the recovery rate for the loan. In fact, some loans will continue to accrue interest and trade at par even after a default and bankruptcy filing if they are deemed to be adequately collateralized.
She also looks for companies that are well positioned on the hierarchy of non-discretionary needs. "In times of economic turmoil, these companies produce products and services that are among the last to be cut from household budgets. In expanding economies, these are the same products and services which increase in consumption."
Another risk McConnell identified is the systemic risk or the collapse of an entire financial system, as many believed we were experiencing in late 2008. The sudden rush to treasuries in October, 2008 caused an unprecedented drop in the normally stable NAV of floating rate loan funds. While temporary, this drop was severe even though there wasn't a significant increase in fund defaults or decrease in recovery rates.
Her Outlook for What Lies Ahead
When asked what she thought was going to be our economic scenario going forward and why this asset class should be considered for our clients' portfolios, McConnell laid out three scenarios for me. "If we face a steep or prolonged deflationary period-which I personally don't think we will-these bank loans will fare better than some other forms of debt due to their senior and secured credit status. This helps to protect principal recovery." She added, "Since interest rates can't go below zero, there is relatively little downside in coupon rates when the LIBOR is only up to 0.5% from 0.25%. In the meantime, the additional yield over investment grade debt will be attractive."
Faced with a scenario of status quo where investors and corporations are skittish and recovery seems to be two steps forward and one step back, McConnell expressed the belief that floating-rate loans would be one of the best places to be in the debt structure. "As corporations continue to stabilize their operating income, these senior loans will be the first to receive the cash flow since they are at the top of the risk structure." She seemed to think that this is exactly where we are today and why the NAV of floating rate funds were almost back to their normal tight trading ranges.
Inflation, normally the worst fear of any fixed income manager, doesn't cause the same reaction in McConnell. "In an expanding economy with inflation, interest rates are also going to be increasing and bank loans with rates that reset every 30 to 90 days will do just fine. In this scenario, investors will like these loans for the stability of the NAV and the attractive yield, just as they always have."
Looking into her crystal ball, McConnell is definitely bullish on the U.S. and her reasons are very compelling, but to avoid being a spoiler, I'll let you hear them from her on Friday at the conference. She is unarguably one of the most intelligent and well informed fixed-income specialists, and you will have to listen hard to keep up with her ideas. She is definitely a master of the floating-rate bank loan universe.