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Bank-Loan Fundamentals Have a Tailwind

Sumit Desai, CFA

Sumit Desai: Hi. I'm Sumit Desai, fixed-income analyst on Morningstar's manager research team. Joining me today at the Morningstar Investment Conference is Michael Buchanan. Michael is head of global credit research at Western Asset Management.

Michael, thank you for joining me.

Michael Buchanan: Thanks for having me.

Desai: Michael, one of the hot topics at the conference this year has been where we are in the credit markets and specifically within high-yield bonds and floating-rate vehicles. Can you talk a little bit about your view of where we are?

Buchanan: I think one of our stronger views is that this is going to be one of the longer credit bull markets that we've witnessed in recorded history, and we don't just say that simply because that's an axe of ours. We say that because we think there are real, real reasons that motivate that. For instance, the severity of what happened in 2008 and the damage that did to corporate psyche, whether it's a CFO, a treasurer, a CEO, they're still very conservative. They're managing their balance sheets very conservatively. They're proactively refinancing. So, they really don't have a lot of near-term refinancing risk.

When we look forward, we still see very supportive fundamentals, and we think fundamentals are what has gotten us to this point since the recovery started. And we still see those fundamentals as a very strong, nice tailwind. We still think this credit market, despite valuations, has some room to go.

Desai: You mentioned valuations, a lot of, I guess, bears who look at this space would argue that valuations are getting a little bit overstretched and a little bit rich. Can you tell me your thoughts about how that plays out relative to the fundamentals?

Buchanan: I think that's exactly right. You have to compare valuations with fundamentals. You can't look at either in isolation, and I think, given how strong the fundamentals are, valuations look reasonable. They certainly don't look as cheap obviously as they were a year ago or two years ago, but I still think that when you look at it on a spread basis, there's room for spread compression. I still think that fundamentals are strong enough to motivate some spread tightening. If you look around the overall fixed-income landscape, I think what you're going to find is that credit, whether it's bank loans or high yield or investment-grade credit, will end up being a reasonable alternative to other fixed-income products.

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Desai: You mentioned bank loans. Can you talk a little bit about how you're seeing the investment trade-off between bank loans and high-yield bonds?

Buchanan: It's pretty close right now, and we've been gradually migrating toward bank loans because really, when we look at the environment, it certainly is an environment where income is going to play a more important role, and the ability to get incremental capital appreciation is pretty minimal. With that in mind, we've started to migrate the portfolios more toward bank loans. We do think it's inevitable that rates are going higher, though perhaps not materially higher. But still having the ability to get that income as well as participate as rates start to rise, I think, is a pretty attractive investment proposition.

Desai: In an environment where rates very possibly could rise over the next couple of years, this is an asset class that historically has had some protection against that. But we've also been hearing about correlations going to 1 in situations of market distress. How do you expect these investments to react in a rising-rate environment?

Buchanan: I think bank loans will do what you think they will. They are going to do reasonably well. You've got to remember that as rates rise, that's usually consistent with an economy that's picking up, that's improving, and with that in mind, we've seen historically that corporate spreads do tighten. And again, what we like about bank loans is that you do participate as rates start to rise. Now a lot of people talk about the fact that there are Libor floors in the bank-loan market, and certainly you know that will initially limit the coupon adjustments as Libor adjusts from where it is currently to closer to 1%. You won't get that coupon pickup, but we also think there will be technical inflows as that's happening that should that support price. So, again, we think when you look at the bank-loan market, it is going to behave like we would expect. As rates rise, it's going to do better.

Desai: What about the risks in the market? What keeps you up at night?

Buchanan: Normally when people ask that question, it would be something fundamental that I would mention. Although, when we look at fundamentals right now, we're pretty comfortable. We think that the fundamental tailwind is there; we think it's pretty hard to disrupt that trajectory over the next year, year and a half. So, we're not that concerned about fundamentals. What we are more concerned about are technicals, and clearly there's been a lot of money going into credit, high yield, and bank loans.

In particular, when you look at the bank-loan space, a lot of that's gone into retail. Retail right now represents about 25% of the overall bank-loan market. So, what we do worry about and what we are watching very closely are those technicals. What if we did have a dramatic turn, and you saw very aggressive outflows in bank loans and high yield? The dealer community doesn't necessarily have the balance sheets that they did four or five years ago due to regulators' risk management, so there's just not that mechanism to dampen severe outflows, and it shows up immediately in price.

Right now, we're comfortable because we know that the fundamentals are so good, so there's certain sort of what I would call valuation points where you see support, where you see incremental buyers come in whether they're insurance companies, capital and income funds, or diversified fixed-income funds. So, right now things are OK, but the thing that really kind of worries us and what we're going to have to watch very closely over the next few years, are, what happens when fundamentals are deteriorating combined with aggressive outflows? And there you know you could have a very aggressive sell-off.

Desai: So given these trends, how have you been positioning the various portfolios that you manage for Western?

Buchanan: Well you know, as I said, we still think the fundamental environment is supportive, and with that in mind we want to take advantage of the potential for spread tightening. So for instance, in our high-yield portfolios, we are still favoring select CCCs, I don't think you can go and randomly buy the CCC rating category; but I think there are some very compelling options within that rating category that offer a lot of upside. We still see the potential for credit improvement, rating improvement. So we do like having that CCC bias. We like having a yield bias versus our peers as well as versus the benchmark. We think that's a smart strategy, especially in a world where we think impairment is going to be very low. When we talk about defaults, we see defaults remaining at these abnormally low levels for at least a year, year and a half.

I also think with the reality that rates are going to rise, you do want to favor shorter duration, high-yield strategies. To me, that's one of the better risk rewards in the market right now, where you can get yield to that first call of maybe 3.5%, 4%, and oftentimes companies are coming in prior to that to refinance and they're paying a tender price. That yield to call of 3.5%, 4% turns into a total rate of return of something well in excess of 5%, 6% even 7%, so we really like that short-duration focus, as well.

Then finally I think going a little bit what I would call off the run. We think the ETF's have gravitated as they should to large-cap very liquid names, and with all the money that's gone into ETFs, whether it's bank loan ETFs or high-yield ETF's, they certainly have, in our opinion, distorted the valuation relative to fundamentals for some of those large-cap names. If you're willing to do your credit work and go a little bit off the beaten track and find those names that aren't as widely followed, we still think there is really compelling opportunity there.

Desai: Michael, thank you for joining me.

Buchanan: Thanks for having me.