Bank Loan strategies are a popular way for investors to potentially hedge rising interest rates, due to their floating rate structure. Additionally, as compared to traditional high yield bonds, these loans carry with them the added benefit of collateralization – assets pledged – which provides the investor a degree of comfort from knowing the loans are secured. Despite concerns about loan standards and pricing, our research has found that these funds may still have a place in client portfolios:
- Quality concerns – Investors have been concerned about Bank Loans for a number of reasons. In particular, lower quality companies represent a large share of the marketplace, leaving investors worried about the quality of the loans available for purchase. At the same time, the proportion of covenant-lite loans has risen. These two trends exist in the context of continuing tight spreads, suggesting rich valuations.
- Low leverage mitigates concerns – Despite concerns over the quality of borrower, there remain relatively low levels of borrowing. Companies have benefited from the low interest rate environment and have broadly termed out their debt portfolios (already taken advantage of lower rates). As such, corporate debt/earnings ratios remain low. Companies have been judicious in re-leveraging their balance sheets, preferring a “wait-and-see” attitude with regard to the economic recovery. We believe this helps mitigate these quality concerns.
- Scrambling for yield – The true area for concern, we believe, is managers who are intent on significantly beating the benchmark and who are therefore left with few options: trade further down the capital structure, or wade into the small/mid-market space. Both of these decision result in a higher risk profile. While these strategies typically outperform during strong credit markets, they tend to significantly underperform during risk-off periods as those loans are typically less frequently traded, resulting in wider bid-ask spreads.
- Stay with what you know – In order to mitigate drawdowns, investors should consider managers who invest in large, broadly syndicated loans that provide liquidity with strong covenants and high probability of recovery in the event of default. These managers are generally avoiding the scramble for yield, and should provide good access to the market beta, without taking on excessive risk.
