INSIGHTS

On May 02, 2017

Senior Variable Rate and Income Closed-End First Quarter 2017 Review and Outlook

Investment Review

In the first quarter, stocks built on post-U.S. election gains in response to encouraging year-end earnings reports, news related to the Federal Reserve’s March interest-rate increase and the Trump administration’s promised tax cuts and regulatory rollbacks. However, momentum slowed toward the end of the period when Congress’ failure to repeal and replace the Affordable Care Act (ACA) raised questions about the future of other proposed market-friendly reforms. The yield on the 10-year Treasury note ended the period a few basis points lower at 2.40%, despite a March spike that preceded the increase in the fed funds rate. European sovereign yields rose sharply in January on political concerns but declined through the remainder of the quarter along with the fading popularity of populist, anti-EU (European Union) politicians.

In this environment, the senior loan sector generated a 1.1% total return in the quarter as measured by the J.P. Morgan Leveraged Loan Index. Senior loan funds (2.6% return on market price) within the closed-end-fund universe outperformed the J.P. Morgan Leveraged Loan Index, despite a modest widening of the average discount to the funds’ underlying assets. Senior loan closed-end funds also fared better than longer-dated U.S. Treasuries and investment-grade corporate bonds, but worse than high-yield bonds and preferred securities.      

Demand for senior loans has slowed from their mid-November peak after the U.S. election, as the yield curve flattened during the quarter. Net inflows into open-end mutual funds that invest in senior loans have dropped by more than 50% since this peak. Notwithstanding this slowdown, open-end senior loan funds have reported positive net inflows in 35 of the last 36 weeks. Near the close of the quarter, this group of open-end mutual funds collectively managed approximately $135 billion in senior loans, 12.3% below the multi-year high set in 2013, when interest rates rose sharply in response to fears that the Federal Reserve would begin to taper its quantitative easing program.

Investment Outlook

As the quarter progressed, uncertainty replaced some of the enthusiasm that greeted the Trump administration’s policies, but we still expect the global economic expansion to continue, even if at a somewhat slower pace. The degree and momentum may depend in part on how successfully President Trump works with Congress to enact regulatory rollback, infrastructure spending and health care legislation. We expect interest rates will rise moderately this year in response to faster growth and an uptick in inflation.

In the United States, policymakers are likely to continue to react to growing inflation, and we expect the Federal Reserve to raise rates again in the near term. However, depending on the path of rate hikes, this could lead to a flattening of the U.S. yield curve, with long-term rates rising much less dramatically if inflation expectations remain in check. While a flattening yield curve is a relatively normal occurrence during rate hike cycles, proposed tax reforms and other initiatives by the Trump Administration may introduce meaningful uncertainty around the path of growth and Fed rate hikes.  

Generally, we see fixed income assets continuing to be more vulnerable to rising yields over time, but believe senior loans remain well positioned relative to other areas of fixed income. Senior loans have characteristics that have historically helped them outperform other fixed income classes during periods of rising interest rates. Their floating interest-rate structure limits duration risk, as rates reset frequently—often every 40 to 60 days. Senior loans also offer the potential for attractive income rates with high levels of diversification due to their low historical correlations to other fixed income sectors, potentially acting as a cushion against rising interest rates.

Ultimately, we believe investment opportunities in senior loan closed-end funds may be largely dependent on economic and employment data, as well as changes in expectations to central bank interest rates—particularly at the Federal Reserve.

­­CRN: 2017-0411-5905R

Opinions in this piece are those of Cohen & Steers and are not necessarily that of AAM.

Data represents past performance, which is no guarantee of future results.

The views and opinions in the preceding commentary are as of the date of publication and are subject to change. There is no guarantee that any market forecast set forth in this presentation will be realized. The preceding commentary does not reflect the performance of any fund or account managed or serviced by Cohen & Steers and there is no guarantee that investors will experience the type of performance reflected in this commentary. This material should not be relied upon as investment advice, does not constitute a recommendation to buy or sell a security or other investment and is not intended to predict or depict performance of any investment. This material represents an assessment of the market environment at a specific point in time, and is not intended to predict or depict performance of any investment. We consider the information in this commentary to be accurate, but we do not represent that it is complete or should be relied upon as the sole source of suitability for investment.

Risks of Investing in Closed-End Funds. Shares of many closed-end funds frequently trade at a discount from their net asset value. The funds are subject to stock market risk, which is the risk that stock prices overall will decline over short or long periods, adversely affecting the value of an investment in a fund, as well as leverage risk, risk of anti-takeover provisions and non-diversification risk.

Senior Loans Risk. The Fund may invest in Portfolio Funds that invest in senior loans. The risks associated with senior loans are similar to the risks of junk bonds, although senior loans are typically senior and secured, whereas junk bonds are often subordinated and unsecured. Investments in senior loans are typically below investment grade and are considered speculative because of the credit risk of their issuers. Such companies are more likely to default on their payments of interest and principal owed, and such defaults could reduce a Portfolio Fund’s net asset value and income distributions. An economic downturn generally leads to a higher non-payment rate, and a senior loan may lose significant value before a default occurs. There is no assurance that the liquidation of the collateral would satisfy the claims of the borrower’s obligations in the event of the nonpayment of scheduled interest or principal, or that the collateral could be readily liquidated. Economic and other events (whether real or perceived) can reduce the demand for certain senior loans or senior loans generally, which may reduce market prices. Senior loans and other debt securities are also subject to the risk of price declines and to increases in prevailing interest rates, although floating-rate debt instruments such as senior loans in which certain Portfolio Funds may be expected to invest are substantially less exposed to this risk than fixed-rate debt instruments.

The J.P. Morgan Leveraged Loan Index is designed to mirror the investable universe of U.S. dollar institutional leveraged loans, including U.S. and international borrowers. The J.P. Morgan U.S. Liquid Index is a market-weighted index that measures the performance of the most liquid issues in the investment grade, dollar-denominated corporate bond market.