Why investors can use loan default rates to predict a recovery (Part 3 of 4)
The distressed ratio
The S&P’s distressed ratio is the number of distressed securities divided by the total number of speculative-grade issues. A speculative-grade issue, popularly known as “high yield” or “junk issue,” is an issue rated BB or lower because of the high default risk attached with the issuer. When these high risk securities go into or head towards a default, they’re called “distressed securities.” Distressed securities are securities that are already in default, under bankruptcy protection, or in distress and heading toward such a condition.
The ratio peaked in 2009, on the face of the economic crisis. However, as the credit markets are stabilizing, the distress ratio has taken a declining trend. This, in a way, means that the number of securities in likelihood of default is reducing. The decrease has come as the economy slowly recovers, though at a sluggish pace from the financial wreck created by the 2008 credit crises.
With a declining default rate and distress ratio, investors are increasingly flocking towards leveraged loans, with a view of an expected rise in interest rates in the near future. The popularity of such loans, made to highly indebted companies, lies in their high and floating interest rates. As the yield on such loans rises with rises in market rates, they offer protection against inflation risk. Enhanced credit profiles, an uptick in capital expenditures from low levels in 2013, and a low default environment are also factors supporting the health of loan issuances.
The popular market index the S&P/LSTA U.S. Leveraged Loan 100 Index, and the performance of leveraged loan ETFs like the Highland/iBoxx Senior Loan ETF (SNLN) and the PowerShares Senior Loan Portfolio (Fund) (BKLN), serve as powerful indicators of the economy.
Broad market indices like the iShares S&P 100 ETF (OEF), which is a large cap equity fund with holdings in blue chip companies like Apple Inc. (AAPL) and Exxon Mobil Corporation (XOM), also show strong indications of where the economy is heading.
The S&P/LSTA U.S. Leveraged Loan 100 Index is designed to track the market-weighted performance of the largest institutional leveraged loans based on market weightings, spreads, and interest payments. The vast majority of these loans are sub–investment-grade, so their ratings are below BBB-.
So, in case of increasing loan defaults, the index (being the prime barometer for the performance of sub–investment-grade loans) would reflect negatively. This would also lead to a rebalancing of the BKLN fund, as the fund normally invests at least 80% of its total assets in the component securities that comprise the index, which are subject to rebalancing and reconstituting biannually, in June and December.
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