Loan sector threats in shifting markets

Identifying future threats - such as technology - to established business models is key to navigating default risk in loan markets, says Alcentra1 European senior loan portfolio manager Graham Rainbow.

Describing the landscape facing loan investors over the next two years, Rainbow points to persistent geopolitical risk and a shifting central bank influence as an ultra-loose monetary policy gives way to central bank tightening.

"Over the last few years we have seen huge central bank balance sheet growth which has significantly impacted fixed income markets and in some cases seen a large growth in negative yielding assets. Now the intention is to change," he says.

"Looking ahead, we believe the recent rise in benchmark rates and increase in credit spread volatility are likely to continue. Widening spreads could cause investors to move to up in credit quality, reducing demand for lower-rated, fixed rate, subordinated corporate paper."

Against this backdrop, Rainbow says it will be critical for investors and portfolio managers in the loans space to minimise exposure to defaults and assess the risk posed by technological advances and changing consumer tastes to the sectors and companies they invest in.

"Lenders are making loans to make a fixed return and get their capital back. But it is crucial to look at the potential risks posed by advances in technology to existing business models. As just one example, technology has had a huge impact on our high street as retail moves from a bricks and mortar presence to online shopping. Change, however, is not restricted to the retail space.

"The ATM sector is also facing up a consumer move away from physical cash to contactless payment and other areas from automotives to telecommunications to travel have seen businesses disrupted by technological innovation and change. The pace of change is quickening, we are seeing very different consumer patterns and investors should avoid companies that are clearly struggling to keep up with these changes."

From a loans investment standpoint, Rainbow sees growing potential in floating rate notes which, he believes are a growing asset class that can offer daily liquidity, limited interest rate risk and low correlation to long duration fixed income.

"Floating rate notes retain many of the positive features of both the secured loan and high yield markets. Many high yield floating rate notes have outperformed in periods of rising rates and have also exhibited low long-term volatility which aligns with stable fixed income asset classes," he adds.

Across the wider loans sector, Rainbow also notes the growing importance of environmental, social and governance procedures. "There is a huge amount of debate on ESG today. We have signed up to UNPRI principles as ESG is a very important part of our credit process and we can only see interest in this theme increasing. Previously a lot of ESG-related thinking centred on fossil fuels and pollution. Now the social and governance aspects of ESG have also become increasingly important," he adds.

1 Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA or the BNY Mellon funds.

The value of investments can fall. Investors may not get back the amount invested. [INV01610].

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Mellon was formed on 31 January 2018, through the merger of The Boston Company and Standish into Mellon Capital. Effective 2 January 2019, the combined firm was renamed Mellon Investments Corporation.