Bank Loans Are Good, but Don’t Expect Miracles
There’s a lot of money flowing into bank loans. As of May 17th, bank loan funds have had 48 consecutive weeks of inflows; year-to-date inflows have totaled a record US$24 billion. Compare that with year-to-date inflows of US$2.6 billion for high yield bonds. In fact, over the past 16 weeks, bank loan funds have averaged over US$800 million per week, and six of those weeks have represented the highest flows ever. A recent Wall Street Journal article covered the topic (paywall). Bank loans are a high yield asset class, which draws a natural comparison to high yield bonds. Consider this – despite the overwhelming positive demand for bank loans, year to date, high yield bonds have outperformed bank loans by over 2% (5.51% for the JP Morgan US High Yield Index vs. 3.26% JP Morgan Leveraged Loan Index). To me, this represents both caution and opportunity. Don’t assume that bank loans, as an asset class will outperform high yield bonds. That said, bank loans can still be a positive contributor if you understand what makes the asset class unique and if you understand what makes one issuer better than another.
One of the first things you need to understand is that bank loans often have very limited call protection – typically less than six months. So with the exceptionally strong demand from investors, companies have been able to call the loans – essentially paying off the debt early and without paying a premium and reissue the bonds with a much lower coupon; thereby, moving their interest costs lower. These features limit the price appreciation of a loan. Whereas, high yield bonds typically have much longer non-call features – around three years typically – which provide investors with price protection and provides for some appreciation. So to pick bank loans, you have to understand the call provisions and how macro circumstances will affect a borrower’s decision to call.
In addition, ultra-low interest rates can have a negative effect on bank loans because of something called a LIBOR floor. The WSJ article doesn’t look at this aspect, but the majority of bank loans are issued with LIBOR floors between 1.0% and 1.5%; the floor limits how low a LIBOR-based rate can go by stipulating that the lender will receive at least the floor. The LIBOR floor can benefit investors when LIBOR drops below the level of the floor; however, this also keeps the loan’s coupon nailed to the floor until LIBOR, currently around 0.275%, moves higher than the floor. So an increase in interest rates will not necessarily result in an increase in the coupon. That’s something to keep in mind if you’re looking for an investment to position for a rate increase.
Another difference between loans and bonds that you should be aware of is in covenants. Bank loans come with certain agreements called maintenance covenants. These require the company to always be in compliance or maintain compliance with the certain financial tests. On the other hand, bonds often have occurrence covenants, which require the company to be in compliance with certain financial tests only if they wish to issue new debt. Loans have maintenance covenants (more onerous) and bonds have occurrence covenants (less onerous), so the advantage goes to high yield bonds. The current strong demand has made it easier to companies to issue loans without too many agreements, called “covenant light,” so we’ve seen more occurrence covenants than maintenance covenants. With less “formalized” protection from covenants, it then becomes even more important to understand the credit risk in the borrower.
The lack of call protection and flex pricing can limit price appreciation in loans. LIBOR floors limit coupon appreciation. Covenant-lite loans would tend to lower recovery rates. All of this would suggest that bank loans have an upside that’s capped at par value. However their downside isn’t capped, since deterioration in credit quality will cause the bank loan to drop much more than it can rise. That’s what we call “negative convexity.” So why buy loans?
Stated simply, if you’re looking to buy loans just to follow the market and own loans, then there probably isn’t much reason. It’s a security-by-security exercise. If you can expertly examine credit risk in the context of macro trends, then you can help offset that negative convexity through security selection. And that can help make bank loans a positive contributor.
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