Is it Time to Consider Bank Loan Funds?

Key Points

  • Bank loans can offer attractive yields, while also potentially benefiting from a rise in short-term interest rates.
  • The recent rise in LIBOR rates has reduced our concern about bank loan "floors" and raised the potential for coupon payments to increase.
  • Bank loans do carry elevated credit risk, and should be considered an aggressive investment.

Looking for an investment that offers high relative yields, but can also benefit when the Federal Reserve hikes rates further? Bank loans may offer both benefits. Those higher yields come with increased risk, however, and bank loans have many characteristics that differentiate them from traditional corporate bonds.

What are bank loans?

Bank loans—also called senior loans or leveraged loans—are a type of corporate debt. Like traditional corporate bonds, they pay interest, have set maturity dates and are generally rated by agencies like Moody's Investors Service and Standard and Poor's. Most bank loans have sub-investment-grade ratings, however, meaning they come with an increased risk of default.1 That's important when considering adding bank loan funds to a fixed income portfolio, as they should always be considered aggressive investments.

While bank loans are a type of corporate debt, they have several characteristics that differentiate them from traditional corporate bonds. Those differences include:

  •  Floating coupon rates. A bank loan's coupon consists of a fluctuating reference rate, plus a spread. The spread is a fixed amount, and can be thought of as compensation for taking on the credit risk that corporate debt offers. The reference rate is usually a short-term benchmark such as the three-month London interbank offered rate (LIBOR). Since three-month LIBOR is highly correlated to the federal funds rate, Fed rate hikes should lead to higher coupon payments for many bank loans.
  • Secured. Bank loans are backed by a pledge of the issuer's assets, such as inventories or receivables. They are senior to most other corporate debt, meaning in the event of a default, a bank loan would be paid before the issuer's other corporate bonds. Secured doesn't mean safe, however: Bank loans still carry sub-investment-grade ratings, and can default. 
  • Liquidity. Unlike traditional corporate bonds, bank loans are private transactions. Rather than trading electronically on the over-the-counter market like most corporate bonds, bank loans often need to be physically delivered (by faxing the paperwork, for example) to the buyer. This makes bank loans harder to sell, and means the loans carry greater liquidity risk than other corporate debt. Liquidity risk refers to the ability of a security to be sold without substantial transaction costs or reduction in value.
  • How to invest. Bank loans are generally issued to large institutional investors, so it's very difficult to invest directly in a specific loan. For individual investors, bank loans are generally accessed through a mutual fund or exchange-traded fund (ETF). Keep in mind that the potential  illiquidity of the underlying bank loans can have a negative effect on the funds that hold them. For funds that are facing redemptions requests, it may be difficult to find buyers for the loans, potentially leading to lower sale prices and lower net asset values for the fund holders.

A Fed rate hike could boost income payments

Three-month LIBOR has been on the rise recently. The Fed's rate hike last December gave LIBOR rates an initial push higher. After holding steady at roughly 0.6% through the first few months of 2016, three-month LIBOR has inched even higher over the past few weeks, in anticipation of new money market rules the Securities and Exchange Commission will implement later this year. Among other changes, those rules will force some money market funds that invest in non-government debt to float in value, meaning they could fall below the $1-per-share value historically maintained by all money market funds. This change is causing many large investors to move out of money market funds whose investments are based on LIBOR rates and into those that invest in government bonds. Weaker demand is pushing down prices, and when prices fall, yields rise.

Three-month LIBOR has been on the rise

Three-month LIBOR has been on the rise 

Bloomberg. Weekly data as of 08/19/2016. U.S. Federal Funds Target Rate - Mid Point of Range (FDTRMID Index) and BBA LIBOR USD 3-Month (US0003M Index).

While the rise in three-month LIBOR is important for bank loans, the level to which it has risen is even more important. Many bank loans have what's known as a LIBOR "floor," meaning the reference rate will never be set below that floor, regardless of the level of LIBOR. For example, let's assume that the coupon on a bank loan is made up of three-month LIBOR plus a spread of 4 percentage points, or 400 basis points, with a LIBOR floor of 1%. If three-month LIBOR were below 1%, as it is today, the coupon would still be 5%—the sum of the 1% floor and the 400 basis point spread.

Today, roughly half of the bank loan market has a floor of 1%. While the coupon payments on those loans didn't benefit from the December 2015 federal funds rate increase, another rate hike could push three-month LIBOR above that 1% threshold. More than 75% of the bank loan market may reset with higher coupons.

Coupon floors become a lesser concern once three-month LIBOR rises above 1% 

Coupon floors become a lesser concern once three-month LIBOR rises above 1%

Source: Bloomberg and PowerShares, as of 8/19/2016. "Bps" is a shortened form of "basis points" (one basis point is equal to one hundredth of one percent, or 0.01%). Statistics represent the holdings of the PowerShares Senior Loan Portfolio ETF (BKLN), as constituents of bank loan indexes are not available. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. 

 Credit risk is still high, but may be less so than in the high-yield bond market

We're concerned with the amount of debt that corporations have taken on in the post-financial-crisis era. Corporations have taken advantage of historically low interest rates to issue new debt with low coupons and yields. However, much of the proceeds of this debt issuance has been spent on shareholder-friendly activities like dividends or stock buybacks, rather than investing in the issuers' business. Poor revenue and earnings growth also pose a risk to corporate bonds.

But a key risk that we see for high-yield bonds today is low oil prices, as more than 15% of the Barclays U.S. Corporate High-Yield Bond Index consists of energy bonds. The growing share of energy issues in the high-yield market may not have been a problem when the price of oil was above $100 per barrel, but it poses a risk as the price has more than halved since the summer of 2014. Lower prices mean less revenue and cash flow to pay creditors, heightening the risk that some companies could default on their debt. But energy issues make up only 3% of the Barclays U.S High-Yield Loans Index, suggesting that bank loans may be more insulated from any potential drop in oil prices compared with the broad high-yield corporate bond market.

Net outflows indicate investor sentiment may have soured

Over the past few years, investors have been net sellers of bank loan funds, a stark reversal of the trend in 2012 and 2013. Large net outflows from the market indicate that, broadly speaking, investors may be underweight these investments.

Investors have generally been selling bank loan funds

 Investors have generally been selling bank loan funds

Source: Morningstar Inc. Columns represent monthly net flows into mutual funds and ETFs categorized by Morningstar Inc. as "bank loan" from July 2011 through July 2016.

We have a neutral stance on bank loans today, but that doesn't mean investors need to avoid them. As investors have moved out of bank loan funds, prices have fallen, on average, making them more attractive today. We think investors should stick with their strategic, long-term allocation to bank loans within their overall fixed income portfolios. If volatility were to pick up in the riskier parts of the market, we think bank loans may be better positioned than high-yield corporate bonds, given their senior, secured status and lower exposure to the energy markets.

What to do now

Consider bank loans if you're looking for investments with higher yields than other short-term investments and the potential to benefit when the Fed hikes rates further. Keep in mind that they are an aggressive investment and should be considered a complement to core fixed income holdings, not a substitute. If you're looking for bank loan investments that may fit your goals, you can research funds using the Schwab Mutual Fund OneSource Select List or Schwab ETF OneSource.

Next Steps

Talk to Us

To discuss how this article might affect your investment decisions:

-          Call a bond specialist anytime at 877-908-1072.
-          Talk to a SchwabFinancial Consultant at your local branch.

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