Vanishing Spreads Amid Refi Activity

Tighter loan spreads cause some concern, but the gradual increase in Libor keeps loans looking attractive.

February 17, 2017

This Bank Loans sector report is excerpted from the First Quarter 2017 Fixed-Income Outlook.

Low default volume, tightening spreads, and robust new issuance paint a strong, healthy picture of the loan market to kick off 2017, but we worry about complacency. We believe this is one of the toughest environments for credit pickers. Refinancing and repricing activity continue to drive the primary loan market, reducing average contractual spreads (the fixed spread over Libor agreed to in the loan terms, ignoring trading prices and expected life of the loan expressed in discount margins). According to S&P LCD, the average yield to maturity for newly issued institutional loans was only 4.8 percent at the end of December, the lowest since March 2014. Yields are likely to decline further if refinancing activity remains the prominent driver of new-issue activity, but this could be partially offset by higher short-term rates. The increase in Libor in 2016 completely offset the reduction in the average contractual spread in loans.

Spreads Are Declining, but All-In Rates Are Rising

The increase in Libor in 2016—approximately 80 basis points—completely offset the reduction in the average contractual spread in loans from about Libor+470 basis points to Libor+390 basis points.

Spreads Are Declining, but All-In Rates Are Rising

Source: S&P LCD, Guggenheim Investments. Data as of 12.31.2016.

Loan market performance remained positive and steady in 2016. The Credit Suisse Leveraged Loan index gained 2.3 percent in the fourth quarter, its fourth consecutive quarter of positive returns, bringing full year returns to 9.2 percent. Lower-quality loans outperformed again in the final quarter, with CCC loans returning 8.2 percent, versus 1.3 percent and 1.9 percent for BB-rated and B-rated loans, respectively. Average discount margins for the index ended the year at only 461 basis points, their tightest since September 2014.

We continue to find loans attractive despite refinancing activity reducing spreads on outstanding loans. With Libor crossing the closely monitored 1 percent level (the floor on most currently outstanding loans), loans that are not refinanced should benefit from a step up in coupons. We remain focused on primary market opportunities where volumes have been robust and some call protection may exist, but we are cognizant of limited net supply that could drive spreads tighter.

Loan Coupons Are Expected to Float Higher in 2017

With Libor crossing the closely monitored 1 percent level (the floor on most currently outstanding loans), loans that are not refinanced should benefit from a step up in coupons. As the chart highlights, the majority of loans have Libor floors of 1 percent or less. Only a small portion of loans with Libor floors at 1.25 percent or above will continue to see coupons unchanged unless they are refinanced.

Loan Coupons Are Expected to Float Higher in 2017

Source: S&P LCD, Credit Suisse, Guggenheim Investments. Data as of 12.30.2016.

—Thomas Hauser, Managing Director; Christopher Keywork, Director

Important Notices and Disclosures

This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.

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