INSIGHTS

On August 08, 2017

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

Investment Review

Fixed income assets produced positive returns in the second quarter, led by high-quality, long-duration securities, which outperformed shorter-duration issues, including senior or leveraged loans, as investors recalibrated their expectations for inflation and central bank rate hikes.

Data continued to point toward a strengthening global economy, as U.S. growth picked up following a relatively slow first quarter, although the figures were somewhat weaker than expected throughout the quarter. The so-called “reflation trade” of expected faster growth and higher inflation that accompanied President Donald Trump’s election in November all but disappeared in the second quarter as anticipated tax cuts and infrastructure spending failed to materialize.

Even as growth appeared to accelerate, long-term interest rates declined as inflation remained subdued, tempered by a decline in crude oil prices. The 10-year U.S. Treasury yield slipped to 2.3% from 2.4%. Despite benign inflation readings, in response to falling unemployment and the potential for wage inflation, the U.S. Federal Reserve (Fed) raised its benchmark short-term interest rate by a quarter point in June, the third such increase since December 2016. As a result, the yield curve flattened, with the spread between 30-year and 5-year Treasury yields in late June reaching its lowest level since 2007.

In this environment, the senior loan sector generated a 0.8% total return in the quarter, as measured by the J.P. Morgan Leveraged Loan Index. In the closed-end-fund universe, senior loan funds performed in line with the J.P. Morgan Leveraged Loan Index on a net asset value (NAV) basis. The funds modestly underperformed on market price, however, with a 0.7% return, as the average discount-to-NAV widened slightly.

Demand for senior loans was strong through most of the quarter, as it had been for much of the past year, with positive inflows into the asset class in 45 of the previous 49 weeks. Year-to-date inflows for senior loans through the end of June reached $17.4 billion, compared to outflows of $6.9 billion in the first half of 2016. Total retail assets in senior loans climbed to $141 billion and now approach the 2014 peak of $154 billion. However, demand for these leveraged loan funds appeared to weaken toward the end of the quarter as recent soft core consumer price index readings left inflation below the Fed’s 2% target and reduced future inflation expectations.

Investor appetite for senior loans was fueled in part by the relatively low credit risk the leveraged loans have presented. At 1.42%, the 12-month default rate for senior loans compares favorably to a recent peak in excess of 4% in 2015 and a high of 14.2% in November 2009.

Investment Outlook

We expect positive global economic growth conditions to persist through the second half of the year, with improving employment and rising personal incomes likely to spur consumer spending and business investment alike. We expect inflation to remain in check for now, due in part to moderating energy prices. Nonetheless, we expect the Fed to continue to tighten monetary policy at a gradual pace and to include the beginning of a reduction in the size of its balance sheet.

With the sharp decline in long-term interest rates in recent months, yields could rise modestly in the near term. Rates could be further pressured by the growth outlook, tight labor markets, current government policies and less-accommodative central banks. Renewed optimism surrounding President Trump’s legislative agenda could also prove to be a risk for the bond market that may push interest rates higher.

From a longer-term perspective, we continue to view fixed income assets as being vulnerable to rising yields. But senior loans offer characteristics that we believe have historically helped them outperform other fixed income classes during periods of rising interest rates. Their floating interest-rate structure potentially limits duration risk, as rates reset frequently—often every 60 days or less. Leveraged loans also offer the potential for attractive income rates, as well as low historical correlations to other fixed income sectors, potentially acting as a cushion against rising interest rates, in our view.

CRN: 2017-0803-6080 R

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

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

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.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at https://www.aamlive.com/legal/commentaries-disclosures.

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