Investor Demand Raises Refi Risk

Reversing the trend earlier in the year, primary market opportunities look attractive as the secondary market trades rich.

December 15, 2016

This sector report is excerpted from the Fourth Quarter 2016 Fixed-Income Outlook.

Almost every aspect of the loan market in the third quarter has reversed trends we observed during the first quarter of the year. The primary loan market has seen robust volume with institutional loan originations totaling $107 billion during the third quarter, the largest since the second quarter of 2014. Default volumes have declined since reaching $8 billion in May 2016, discount margins have tightened, and prices have been buoyed by strong CLO demand and loan mutual fund inflows. In fact, S&P LCD data shows that visible demand for loans has outpaced net supply for seven consecutive months, the longest such stretch since 2009.

Loan Demand Has Outpaced Supply for Seven Months

Strong CLO originations and a resurgence in mutual fund demand has allowed visible flows to outpace net supply in the loan market for seven consecutive months. This is the longest streak of such supply/demand dynamics since 2009.

Loan Demand Has Outpaced Supply for Seven Months

Source: S&P LCD, Guggenheim Investments. Data as of 9.30.2016.

Supported by a strong technical backdrop, the Credit Suisse Loan Index gained 3.1 percent in the third quarter. Lower-quality loans outperformed, with CCC loans returning 7.5 percent, versus 2.1 and 3.3 percent for BB and B-rated loans, respectively. Prices continued their recovery with BB-rated loans now trading above par, and B-rated loans trading at around 97 percent of par, on average. Average discount margins for the index tightened 79 basis points over the quarter to their tightest since September 2014. Year over year, the loan market has delivered 9.2 percent total return through the end of the third quarter.

In the current environment, call protection periods and call prices must be taken into consideration when assessing loans trading above par. Almost half of the loans in the Credit Suisse Leveraged Loan index are now trading above par, despite many loans now being outside of their call protection period. As the chart below shows, borrowers opportunistically refinance or reprice their outstanding loans when they trade above par, a strategy that has allowed borrowers to reduce borrowing costs since 2009. This prudent strategy, while credit-positive for borrowers, can cut into investors’ expected returns. For this reason, we are focusing on primary market opportunities where volumes have been robust.

Premium Loans Carry Refinancing Risk

As secondary loan prices rise above par and yields fall, borrowers take the opportunity to refinance outstanding loans and reduce their all-in borrowing cost. Therefore, while the rebound in loan prices has been positive for loan investors that rode out the volatility, these conditions must be monitored against limited call protection to avoid paying above a call price.

Premium Loans Carry Refinancing Risk

Source: S&P LCD, Credit Suisse, Guggenheim Investments. Data as of 9.30.2016.

—Thomas Hauser, Managing 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.

Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management. ©2016, Guggenheim Partners, LLC. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC.


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