Investment Product Review

 

In this series we examine investment products and strategies, from the mundane to the highly complex, explaining how they work and why we do or do not use these particular products or strategies in our portfolios.

Bank Loans: Cutting Through The Hype

Bank loans (also known as senior or leveraged loans) have become an increasingly popular investment in the past year or two.  On the surface, these securities seem to offer the best of both worlds; a high current yield along with a built-in protection against rising interest rates.  However, as is the case with all investment products, there is no free lunch, and investors should only expect to be rewarded for the risk they take.  In this Investment Product Review we will take a deeper look at bank loans, and identify the costs and benefits of including this asset class in an investment portfolio.

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Bank loans are privately-traded senior secured loans, usually with a floating coupon rate, made to companies that are generally rated below investment grade.  The “senior” name refers to the fact that bank loans are senior in the capital structure to other forms of debt, such as unsecured high yield bonds and subordinated mezzanine debt, as well as preferred and common stock.  The average loan has a term of 5-8 years, which tends to be shorter than that of high yield bonds.  Bank loans also offer a floating rate, generally stated as LIBOR1 plus a pre-determined spread, which will be based on the perceived credit risk of the company issuing the debt.  For example, a company might take a loan at L +450, meaning LIBOR plus 450 basis points, or 4.5%.  If LIBOR was currently at 0.65%, the rate on the loan would be 5.15%.  Though the interest rates are quoted on an annual basis, the loans themselves pay interest quarterly, and their payable rate is reset on a quarterly basis as well.  This gives bank loans the rare characteristic of being an asset that can directly benefit from rising interest rates.

Like all corporate debt issuances, bank loans are subject to the credit risk of the issuing company.  Because these companies are generally below investment grade, this credit risk can be considerable, on par with high yield bonds.  However, because bank loans are senior to high yield bonds in the capital structure, they have a higher payment priority, implying a higher recovery rate in the case of a default.  Bank loans are almost always callable at par, meaning that they will rarely trade at a premium.  This means that as a company improves its credit standing, it will be able to call outstanding loans and replace them with loans with lower rates (i.e., a smaller spread).  Clearly, a company would not refinance and pay more if their credit quality deteriorated, so in this sense investors in bank loans are exposed to asymmetric risk of the loan issuer’s credit standing.

As mentioned above, bank loans generally will have an increased payout to investors as a result of rising interest rates, but this is not always the case.  Many newer loans are now being issued with a “LIBOR floor”, meaning a minimum rate that must be paid regardless of the current level of LIBOR.  Using our earlier example, the loan priced at L +450 might have a floor at 6%, so even though the combination of LIBOR and the spread might be below 6%, the loan itself will never pay anything less than 6%.  A loan currently at its LIBOR floor would be subject to interest rate risk (i.e., the risk of losing value as interest rates rise) until LIBOR rates were such that the loan traded above its floor.  Additionally, while LIBOR is the reference rate used in the pricing of these loans, it represents short term interest rates, and can move in a very different manner than longer term rates at any given time.  Thus, longer term rates could increase during a period in which LIBOR was flat, or even decreasing.

Perhaps the least well understood risk of bank loans is market liquidity.  Bank loans currently have an outstanding value of about $767 billion2, which may sound large in absolute terms, but is in fact barely 2%3 of the outstanding value of the US debt market.  While in normal market conditions loans are traded frequently enough currently to provide adequate liquidity, there is a distinct possibility that during a volatile market period, mass selling in the bank loan sector could cause liquidity to dry up, forcing investors to accept large losses in order to unload their loan holdings.  This is a very important consideration for investors when deciding in which form to hold bank loans, should they choose to do so.

There are several possible methods available to those who want to invest in bank loans.  As mentioned above, loans are privately traded (i.e., not traded on market exchanges), meaning that it is quite difficult for an individual investor to gain access to individual loans.  However, the recent interest rate environment has led to an increase in the popularity of bank loans, so there has been an increase in the number of offerings available to individual investors.  Among these are mutual funds and ETFs that invest primarily in bank loans, allowing even small retail investors access to a previously inaccessible asset class.  While the low minimums and apparent liquidity are appealing, investors should bear in mind that these funds are vulnerable to the aforementioned liquidity risk.  This means that in volatile markets, mass selling of a publicly traded loan fund could force the fund managers to unload some of their holdings at discounted values in order to generate cash to cover redemptions.  Another possible avenue for investors is through privately traded vehicles.  These private funds are able to restrict investor liquidity, providing some protection to investors from the adverse effects of panicked selling, though also constraining their own ability to liquidate their holdings.  Additionally, private funds tend to have significantly higher fees, generally using the same “2 and 20” fee structure4 as is commonly employed by hedge funds and private equity managers.

Bank loans are assets that have characteristics that are particularly appealing in the current low interest rate environment.  They have relatively high yields, they pay a floating rate that may increase with market interest rates, and they are secured debt which is senior in the capital structure.  They also possess a somewhat unusual set of risks, some of which are dependent on the method of investment used.  We encourage all investors to carefully consider the risks of any new asset class and consult with your advisor before investing.

References
1. The London Interbank Offered Rate, which is the average rate at which banks will lend money to each other in wholesale money markets.  LIBOR is calculated daily, and is used as the primary global benchmark for short term interest rates.
4. This refers to a 2% management fee and 20% carried interest (meaning the manager receives 20% of profits over a given minimum performance level).

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About Erik Lehr

Erik graduated from the University of Oregon with a Bachelor of Economics and Mathematics degree. His background includes master’s degree in economics and a Master of Science in Computational Finance and Risk Management from the University of Washington. Erik also holds the Chartered Alternative Investment Analyst (CAIA®) designation.

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