Is direct lending an alternative to bonds?

Low volatility, attractive yields and floating rates: all reasons why, according to Alcentra’s Paul Hatfield, loans are more than a match for bonds in the long term.

Bonds ought to be more volatile currently, given the US political environment, potential shifts by the world’s main central banks and continuing geo-political risk from North Korea. However, even with this backdrop, we have not seen much in the way of volatility. Why is this? Many investors are sitting on larger cash balances than has historically been the case and all are desperately looking for more yield, preferably without taking too much extra risk. In today’s world, that isn’t always an easy riddle to solve.

Inflation has at long last started to show its face again in Europe, but only on a minor scale. It hasn’t appeared in the US, meaning a less convincing case for the Fed to raise rates. That said, the economic news out of the US continues to improve with the recent revision of GDP growth for QE 2017 being the latest positive trend to emerge.

Even if this doesn’t result in a rate rise, the Fed may feel emboldened to begin unwinding its balance sheet, something which would have the same net result. The constant threat of a US government shutdown as discussions about the debt ceiling become more strained – and more tied to politically partisan issues – is likely to have a greater effect and this could stay the Fed’s hand.

For the ECB, while economic activity and sentiment have picked up and there are straws in the wind for inflationary expectations, Mr. Draghi is unlikely to waiver from his previous commitment to QE until these trends are more firmly established.

For European bonds, this means continued pressure on already low coupons and probably further spread tightening. On paper, this might make them look attractive in the very short term, but the spread widening that would follow any change in the ECB stance would be significant and potentially highly painful for investors in sovereign, investment-grade and high-yield bonds.

So where can investors find relative value in this scenario? Volatility is likely to be most apparent in equity markets, but with economic fundamentals reasonably strong, US high-yield bonds are attractive on a relative value basis. The Q2 earnings season was solid and with rates still low, even after any further Fed rate rise, defaults will remain very low.

Alternatively, loans offer even lower volatility and reasonably attractive yields with the added advantage of being floating rate, so that they immediately benefit from any rise in rates. While less volatile, direct loans to smaller companies (SMEs) are significantly less liquid than high-yield bonds, so investors need to take that into account in making any decision.

European loan markets have seen large-scale inflows recently in both larger broadly syndicated bank loans, as well as smaller direct loans to SMEs. This has put some pressure on margins and in some cases led to weaker documentation, as sponsors have pushed for more aggressive terms. This phenomenon is much more apparent in the larger end of the market where issuance of new loans has not been sufficient to soak up all the inflows to loan funds. September is likely to see these technical factors shift markedly, with a raft of new issuance coming to the loan market. This will shift the power back to lenders and away from borrowers, so margins are likely to rise again.

In the direct lending area, margin pressure and aggressive terms appear to have been more confined to the smaller end of the market. There is more competition among the more newly established direct loan funds, which are trying to grow and gain market share. The flow of new direct loan opportunities is still extremely strong, meaning larger funds can afford to be more selective and discerning in their investments. With European banks still facing major balance sheet issues, the direct lending opportunity is still growing. The market is relatively unaffected by the issues causing volatility in the bond markets, with individual company-related credit issues being the most important factor. Since the loans are not mark-to-market, pricing volatility is extremely low.

So loans can provide an attractive alternative to bonds and equities, especially in times of rising rates. They are lower in volatility and less correlated to equity and bond markets. However, investors need to bear in mind that they are less liquid, especially at the direct lending end of the spectrum.

Returns on broadly syndicated bank loans are more stable in the long run, but they are usually slightly lower, reflecting the lower risk and the greater security that loans have compared with bonds. Direct loans offer a high premium for their illiquidity, meaning they are more than a match for bonds in the long term.

Paul Hatfield is global chief investment officer at Alcentra, part of BNY Mellon Investment Management.