Stewart: Real bond yields are on the rise for the first time in ages, and we're here to talk about leveraged credits, specifically floating-rate bank loans with Paul Massaro, head of Global High Yield and lead portfolio manager for Floating-Rate Strategies at T. Rowe Price. Welcome, Paul. How are you?
Paul: I'm good, Stewart. Thank you for having me.
Stewart: Thanks for being on. We're going to start this one the way we start them all, hometown, first job of any kind, fun fact.
Paul: Hometown is Western New York, Rochester, a diehard Bills fan, true and tested. First job of any kind would be the theater, Sony Theaters on Monroe Avenue in Pittsburgh, New York.
Stewart: There you go. And fun fact?
Paul: Oh, fun fact would be... No, I think that would be my fandom of Bills that would be the most fun.
Stewart: You're a serious Bills fan.
Paul: It's looking good this year, Stewart. It's looking good.
Stewart: I like that.
Paul: I have high hopes.
Stewart: So, let's talk about these markets because I need some education. Most of us are familiar with the high-yield bond market. We're here to talk about that and also specifically, the bank loan market. What's the difference at 50,000 feet? And then, let's talk about what's the difference at 10,000 feet?
Paul: Sure. So maybe starting with high-yield, it's about a $1.5 trillion market in size. And I would say these are all names in this market, of course, sub-investment grade with rating agencies below triple B. It is dedicated to the fixed rate portion of the market and they're all unsecured in nature. And what you would typically see in the high yield market would be maturities of 8 to 10 years' length and a traditional non-call period for about half of that time period. The market has shown really well over time on a risk-adjusted basis and it's very much diversified by credit quality, by industry, with the largest sectors being a little bit more on the cyclical side with automotives, energy, and cable.
At the highest level, the bank loan market is pretty similar in that there's a lot of overlapping names, maybe about 70% of the names in both markets are the same, but we think of the loan market as much more of a defensive way to play those same sub-investment grade opportunity set. And if you think about the bank loan market, it's focused very much on secured debt, so first lien, top of the capital structure, most senior, and generally backed by all the hard assets of the firm. It has higher recovery rates than the high-yield market over time, if anything, did go south. And, the market has grown handily in recent years given the private equity sponsors' preference for this market and is now, just about the same size as the high yield market, about 1.5 trillion in size.
When you take a look at the loan market, it is focused mainly on floating-rate coupon debt, so a base rate, LIBOR, which is transitioning now to SOFR, plus a margin, typically with a floor on the base rate. And those loans are generally six to seven years in length and generally don't stay out for that long. And while the return profile is slightly less than high yield volatility, it’s meaningfully less. So on a risk-adjusted return perspective, it actually ends up better on a sharp ratio. The market in loans is also diversified by sector and credit quality, but it has a bit of a more defensive industry composition where the largest sectors would be things like healthcare, services, and technology.
Stewart: The less volatility is by nature of the fact that it's got a lot less effective duration than the high-yield market, right? I mean that's got to be the driver of a lot of that.
Paul: So that's right, but also because you're higher up in the capital structure and you're secured, your risk of loss is lower, right? If you take a look at the recovery rates over the long term for the leveraged loan market, let's call them in the mid-60s, whereas if you take a look at high yield, maybe you were in the 35-cent to 40-cent type of range. So that comfort, that extra level of seniority I actually think also contributes to the lower volatility over time.
Stewart: Does that translate into less spread volatility as well?
Paul: It does. It does. So, you see that in a number of the different markets, a number of the different downturns, and we've seen it this year as well with just the returns relative, loans versus high yield. I think the outperformance of loans versus high yield is 900 to 1000 basis points at this point1, so you definitely see that.
I think one other thing, Stewart, to maybe emphasize in the differences in the markets, and some of the investors we talk to think about the loan asset class and focus on it just in times of rising rates, right, because it's got that floating-rate coupon and people are very focused on it when the Fed is in their hiking cycle. But to us, it is really a strategic asset allocation over time. And that secured nature of the asset class we think really is important.
It's also generally negatively correlated with a fair number of other fixed income alternatives because it has that floating-rate coupon, so it works well in a very broad and diverse fixed income portfolio. The yield is pretty similar to what you would find in the high-yield market. And I think that all shows through in the long-term performance numbers.
And one of the things we talk about with our clients is, I think that is just very overlooked in the market is, over the long term, the loan market has generated positive returns for investors in 24 out of the last 25 years, and we think that's really impressive. There's been a lot of different interest rate cycles during that time. There's been a lot of different economic cycles. And I think that speaks to the very durable nature of the returns that it can perform in a lot of those different cycles. So we think of it as more of a strategic asset class rather than just tactical with rates.
Stewart: Yeah. I think if you look back at this year today, you've got the Ukrainian invasion, persistently high inflation. I paid over six bucks a gallon for diesel the other day.
Paul: Yeah.
Stewart: The Fed is aggressively tightening, rates are rising. There's a lot of pressure, right? And yet to your point, leveraged credit has outperformed both traditional fixed income and equity markets. It's worth noting. I mean I simply, before you and I started talking, I had no idea that that was the case. So I think it does speak to the durability of that asset class.
The Fed is out here. They seem to have a singular focus here to mute the inflation on rising rates, that turns into recession risk, right? Every time, and you and I have been around a while, whenever you see this aggressive Fed tightening, you see the curve get flatter, you start to get a little uneasy in your chair. Has your credit default outlook changed any, worsened is the way I'd lean, but has it changed any, given what you've seen over the last six months?
Paul: Yeah. So look, it's clearly gotten tougher out there, right? And we came into the year not really I think pricing in a major war in Ukraine, and the runaway inflation that we've clearly seen this year. And the Fed is doing everything it can, right? It's very determined to get inflation down, but it's working with some very blunt tools. It can't fix everything in terms of the supply chain in China. It can't fix the Ukraine war. It can raise rates and it can slow down the economy, and they seem determined to do that. So look, we are an economically sensitive asset class. Naturally, there will be some impacts on our credits in our market, but at this time, we're not forecasting a significant spike in defaults. Companies have generally used the last few years to extend maturities and bolster liquidity. So if you look at cash on corporate balance sheets, it's in great shape. There's no maturity problem in the asset class.
At the margin, will there be names that don't have a lot of cushion and can't withstand higher inflation or higher interest rates? Sure. That's absolutely going to happen. But at this time, we're not forecasting a spike in defaults like a COVID or a GFC-type experience. How we're looking at it on the micro level, and the consumer is actually still in very good shape and they have a lot of savings built up over the pandemic timeframe with all the stimulus. Take a look at the labor market that continues to be strong with several orders of magnitude higher in openings than the supply of labor. And like I said, the corporate fundamentals in terms of liquidity and cash levels are very solid. That's all balanced by just this overwhelming macro of the Fed weighing in here, the challenging inflation backdrop, the war, and the potential that recession probabilities are higher, are clearly higher than they were just six months ago.
Stewart: So you mentioned a term that I'd like to just unpack a little bit. You mentioned cash on corporate balance sheets and a lack of maturity risk. Is that to say that there's not a risk of a bunch of corporate debt coming due and eating up that cash? Is that what you're referring to? I'm taking a guess.
Paul: That's exactly right. So if you take a look at what happened over the last few years, not only... Even pre-COVID, rates were getting pretty low and companies, too, took the opportunity, particularly in the high yield market to extend out those maturities and they were very opportunistic. We saw double B companies in the high yield market print coupons at three and a half percent, for example, and they locked that in for 8 to 10 years, so in so doing... And as well, they did that during the pandemic when they needed extra liquidity and needed some bridge capital to get through the pandemic, and so by all of that, they extended out their maturity profile. So that if you look at it today and just kind of take a look at the whole market, maybe 5% of the market comes due in the next two years, which is very manageable and really not an issue. So it would be a bit different, right, if we were staring at this tower of maturities that we had to get through in the next couple of years and the capital markets were frozen.
Stewart: So you mentioned that you're not forecasting a spike in defaults. There must be some metrics that you're monitoring. What are the key risks that you look at, underwriting standards and so forth, and how are you managing those concerns as the ground beneath us is moving?
Paul: Yeah. And I'd say even if we get an increase in defaults, we think it will be manageable, but we're starting from a spot here where we are well below long-term average default rates. So even moving from something like 1.5% to 2.5% or 3% just gets you back to kind of a long-term average. But in terms of the risks out there, look, other than the broader macro issues and the outlook that we've gone over, some of the concerns are the underwriting standards and always are in this asset class.
So your research team has to be diligent about the risks that we're taking. I think our process is very robust in examining the merits and risks of each individual investment. We're looking at the cash flow forecast. We're looking at indicative credit ratios over time. We're looking at the strategic value of the company and we're trying to evaluate the management team and other factors, right? So what would this company be worth to a competitor? Am I covered in my debt position? And then, of course, what are the features in the individual loan or bond covenants that would make it more attractive of an investment?
But there are times when there is so much demand for paper that the issuers begin to have the upper hand on underwriting standards and those underwriting standards just deteriorate given there's so much demand in the market. And during those times, in terms of our reaction function, you see us pull back on new issue participation. That is generally what we do. And the last time this happened was in 2018 and into 2019 where you saw our new issue participation move meaningfully lower, really into kind of the mid-teens type area, but that's pretty cyclical, right? And it really is determined on what the demand and supply situation is in the market.
For example, in 2020, during COVID, you saw our participation rate went up because those deals were actually very well structured and had some great features, and some of those new loans, given the market was in a difficult spot and were very attractive. I'd say one other related theme in terms of key risks that we're monitoring would really just be the overall shift in credit quality of the asset class. The asset class is very strategic with a very attractive, it's got, as I mentioned, the senior secured nature floating-rate coupon, but one of the things that we have seen over the last few years is a shift in overall credit quality towards lower quality into the single B land. And private equity sponsors have used the asset class pretty robustly in recent years to lower their cost of capital and they really like the callability feature, being able to pay these loans down at par without a prepayment penalty.
So that has driven the share shift from high-yield into loans. And it has driven mix shift in credit ratings down into the single B part of the curve. So we're definitely keeping our eye on, not only the single B part of the curve, but the low single B, that B3, B minus area, because in a recession or in a significant downturn, you could see meaningful downgrades in that area of the market.
Stewart: And so I gather that you are constructive on the asset class overall, in spite of some economic uncertainty looking out here, given the structure and the performance of the asset class under similar circumstances.
Paul: Yeah. Look, our view is pretty balanced at the moment. I mentioned all the positives around the corporate fundamentals or the consumer balanced by the macro issues, but we feel good about the names in our portfolios. I still feel like there's some pent-up demand as we continue to recover from the pandemic. And I think the one thing that we're focused on now in terms of expectations is if you look at forward returns, you're looking at a market now where the median forward return when you reach this dollar price is over 9.5% generally when you look back at the history of the asset class. So we're trading around 93 cents on the dollar. The market yield is around 8.75%.
And when you generally get to those types of levels, yeah, it's a difficult market, there's a decent chance of recession, but if you're entering at those dollar prices, your median forward returns are generally very good. If the market were to cheapen even further and get to a dollar price of say around 87 cents on the dollar, if you go back in history, your one-year forward returns from that point are all positive. So we're getting into some attractive valuations here. Yeah, the macro was more challenging than it was. We definitely have more headwinds than we did last year, but I think it's that valuation argument that it's getting more compelling for us.
Stewart: So T. Rowe Price has been a player in the insurance market for a while and I think your presence is much larger than is broadly known. I know that you have insurance company mandates in this asset class. Can you talk a little bit, given that our audience is overwhelmingly insurance investment professionals, what are some of the key portfolio considerations when you're looking at insurance mandates in particular?
Paul: Yeah, it is a bit of a different approach, but book yield is generally the primary objective that separates our, say, total return mandates from our insurance mandates and that does, in a lot of cases, drive different decisions. I think we have to look at what book yields are existing in the portfolios and what we can replicate in the current market. And, a lot of our conversations are around book yield accretive swaps, right? Challenge every day is one that we look forward to, it's trying to find where we can swap into a book yield accretive new security without really changing the broad makeup over the overall credit quality of the portfolio. I think that's what our clients really want us to do.
I'd say some of the more robust conversations and maybe the more rewarding conversations I think with our insurance clients are really when the market sells off, right? And we find that they're very willing to step into some of those higher yield levels when we see them. Generally, the windows are pretty short, right? When we saw during COVID the market widened, and the high yield market widened 500 basis points in about nine trading days. So just the ability to react, the ability to put capital to work, I think some of our insurance mandates and our insurance clients really believe in the strategic nature of both high yield and bank loans and those are very rewarding conversations I think when you're able to step into some very attractive book yields 'cause you're locking those in for a number of years.
Stewart: So, Paul, you mentioned T. Rowe Price's investment process earlier. You obviously have a very robust credit team. Can you talk a little bit about the investment process and what differentiates it?
Paul: Sure. Yeah, I think, look, we have a very long-tenured team, with a durable, and I think repeatable proprietary research process. I think the thing we like about it as well is it's one team that covers both high yield and loans, and we talked about earlier, the amount of overlap there is in those credits between the two markets. So that gives us some real efficiency and synergies, but I think it also allows us to capture inefficiencies in the markets over time. About 30% of the high yield market today is actually first lien senior secured in parity with the bank loan market. So that one team that's looking at that holistic view of the capital structure can give us the ability to find the right security with the best value and capture those inefficiencies between the two markets.
I think one other thing that we talk about a lot with our clients is, of course, the theme of collaboration and you see that across T. Rowe, but I think it's especially prevalent on our team. We're very fortunate to be a very strong high-yield team, but be within a much larger research organization, right, with hundreds of equity analysts and a ton of access to management. So I personally think the thing that differentiates us the most is that ability, and willingness to share those insights across teams and across divisions. I think that's what actually provides really good outcomes for our clients.
Stewart: So can I just go back to something you said? You used the term parity when you talked about high-yielded bank loans. Can you just unpack that term? I'm a recovering fixed income geek, but I thought maybe we might have some folks who don't know the term.
Paul: Yeah. It simply means you are equal in seniority. So when you think about, I discussed the high yield market earlier as being generally unsecured in nature, there is a portion of that that is secured and ranking equal to the loans in the market. So it's simply, think about it as a bank loan in bond form. First lien senior secured, same collateral, same seniority, same ranking in the capital structure, but in those situations, we're able to buy a bond that maybe has a little bit of a higher coupon and has more call protection. So we're not taking any additional credit risk, but we might be getting a better-structured security that offers better return.
Stewart: And that has a significant impact on performance oftentimes, right, so…
Paul: Exactly.
Stewart: Just kind of on the tail end of this thing, where right now, as I look out, I'm a CIO, I'm running an $8 billion book and every day is the same. I pull the blinds up on my window and I look out and I've got to put money to work. And the insurance industry has a strange problem, which is the more successful the company is in selling premium, the faster the investment team has to invest those dollars. And you mentioned book yield accretive trade, which is something that increasing book yield hasn't been possible for many years, right? So when you look out across the horizon, where are you finding value with high conviction in this particular market environment?
Paul: Yeah, so we're finding good value in the market overall on dollar price. But to me, I'd say the most attractive part of our market right now would be on the shorter end of the maturity curve. We're seeing a lot of situations where the curve is inverted and you're getting actually more yield and potential return for shorter maturities. And in some cases, we're seeing technical pressures, given either outflows or other issues, where some of those shorter maturities get sold first. And if you could be the liquidity provider on the other side of that, not only do we think those are very attractive yield opportunities, but I think our confidence and conviction in the forward curve in that timeframe in the next one to two years is the highest versus our conviction in the forward curve five, six, seven years down the road. So I think that's an area that we're very focused on now.
I think on a sector basis, we're also continuing to see some opportunity in things like leisure, entertainment, and travel, which actually continue to have very strong results as a recovery from the pandemic. And I think this is also a market where we will be looking very closely at new issuance, right? We discussed earlier how if the market's having a difficult time, some of those new issuance opportunities could be very attractive. To us, all of the opportunistic refinancing new issuance is off the table for now. So any deals that do come to market are deals that need to come to market and the buy side should be able to extract some pretty good terms on those deals.
Stewart: That's fantastic. Paul, listen, thanks for... I got a great education today. I'm always the one that learns the most on these podcasts. It is just fantastic. So thanks a lot for being on.
Paul: Stewart, it was great being with you. Thanks very much.
Stewart: Absolutely. Paul Massaro, head of Global High Yield and lead portfolio manager for Floating-Rate Strategies at T. Rowe Price. My name's Stewart Foley. I've been your host and this is the InsuranceAUM.com Podcast.
1 Year to date, 6/30/2022.
Sources: S&P/LSTA Performing Loan Index and J.P. Morgan Global High Yield Index.
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