What You Need to Know

Investors have rushed into bank loans, hoping that loans’ adjustable coupons will protect them against rising interest rates. But many are overlooking the low credit quality of today’s loans. With credit assets looking expensive and the US in the late states of the credit cycle, we think now is a bad time to bet big on bank loans.

Investor flows into bank loan mutual and exchange-traded funds in 2017.

The share of the bank loan market that lacks strong protections, or covenants, for lenders, as of June 30, 2018.

The amount, as of June 30, 2018, by which the trailing one-year dividend of the largest bank loan ETF declined, despite seven Fed rate hikes.

Bank loans have delivered attractive returns so far this year, and there are times when it may make sense to include them in a diversified fixed-income portfolio. But we don’t think now is one of those times. The way we see it, many investors have rushed into loans without understanding the risks.

When it comes to protecting investors against rising interest rates, floating-rate bank loans have overpromised and underdelivered. As a long-term income generator, they’ve been a poor substitute for other types of credit exposure. Perhaps most importantly, the loans being extended to companies today are riskier than ever.

To make better portfolio decisions, it’s critical that investors get to know the whole story.

Both high-yield bank loans and high-yield bonds offer investors high income potential in exchange for the risk of lending to firms with low credit ratings. But loans have two key features that high-yield bonds typically don’t have.

Floating Rates: Loan coupons adjust periodically based on changes in short-term interest rates. So, when the Federal Reserve is raising rates, the income that loans produce should go up as well. This helps to make their duration, or sensitivity to interest-rate changes, lower than that of high-yield and investment-grade bonds.

Seniority in Capital Structure: Bank loans are secured by the borrower’s collateral, which gives them seniority over unsecured bonds in a company’s capital structure. If a company defaults, bank loan recovery rates should be higher than those on high-yield bonds, giving investors an extra layer of credit protection.

Together, these two features appear to shield bank loans from both interest-rate risk and credit risk. But the reality is quite different.

First, bank loans don’t always behave like floating-rate instruments should. The reason is that bank loans are callable. Last year, 73% of outstanding bank loans were refinanced or repriced as high-investor demand drove down yields and credit spreads. The share of bank loans trading above par rose above 70% in early June of 2018 before falling as supply finally started to outstrip demand.

Second, the quality of today’s bank loans has declined. Lately, borrowers have been offering less covenant protection for lenders. Before the global financial crisis, less than 20% of the high-yield bank loan market was what’s known as covenant-lite. Today? It’s around 75% and growing (Display).

Bank loans have also surpassed high-yield bonds as the most popular way to finance leveraged buyouts—the riskiest type of corporate takeover. This trend suggests that default risk is a lot higher than many investors realize. And when those defaults happen, we think recovery rates are likely to be a lot lower than they’ve been in the past.

Bank Loans' Prices Matter More Than Interest Rates

Many investors have rushed into bank loans without understanding the risks.

Should fixed-income investors simply buy high-yield bonds instead? Not necessarily. Both segments are expensive today and have a thinner cushion against future losses. This matters, because the US is in the late stages of one of the longest credit expansions on record. When the cycle turns, both bank loans and high-yield bonds are likely to underperform.

But we think bank loans’ underperformance will be more severe. As we’ve seen, high demand has driven up the average bank loan price. And our research shows that average price has historically been a better predictor of performance than the level of interest rates.

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