Are Bank Loans Right for You?

Bank loans might seem compelling today, but investors should be aware of their nuances before considering them.

The floating coupon rates offered on bank loans may seem attractive as the Federal Reserve hikes rates, but rising interest rates may make some loans riskier. When interest rates rise, the cost of borrowing by the issuers rises. Since most of the issuers carry sub-investment grade ratings, and "junk" rated debt tends to perform poorly when economic growth slows and the risk of recession rises, we believe bank loan prices may fall in the near-term.

Before we dive into more detail, it's important to understand what bank loans are. Bank loans, also called "senior loans" or "leveraged loans," are a type of corporate debt that have a few characteristics that differentiate them from traditional corporate bonds:

• Sub-investment-grade credit ratings. Bank loans generally have sub-investment-grade credit ratings, also called "junk" or "high-yield" ratings. Junk ratings are those rated BB+ or below by Standard and Poor's, or Ba1 or below by Moody's Investors Services. A sub-investment-grade rating means that the issuer generally has a greater risk of default, so bank loans should always be considered aggressive investments.
• Secured by the issuer's assets. Bank loans are secured, or collateralized, by the issuer's assets. They are also senior in a company's capital structure, meaning they rank above an issuer's traditional unsecured bonds. Despite that secured status, bank loans should still be considered risky investments given the aforementioned junk ratings. In other words, "senior and secured" does not mean they are safe investments.
• Floating coupon rates. Bank loan coupon rates are usually based on a short-term reference rate plus a spread. The short-term reference rate is usually a short-term London Interbank Offered Rate (LIBOR) or the Secured Overnight Financing Rate (SOFR) although that will likely change in the future as LIBOR is set to be retired by June 2023. The spread above the reference rate is meant as compensation for risk assumed by lending to risky companies.

Bank loan floating coupon rates have been a key driver of their performance this year. While many bond investments have suffered their largest losses in decades, bank loan total returns are only down 2.1% this year.

One of the tenets of bond investing is that prices and yields tend to move in the opposite direction. That's not necessarily the case with bank loans, however. If short-term interest rates rise, their coupon rates rise as well so their prices don't need to adjust lower. In other words, bank loans have low interest rate risk, a key factor that's prevented their prices from falling as much as other bond investments this year.

We see three key considerations with bank loans today:

Higher short-term interest rates mean that bank loan investors should be rewarded with higher coupon payments. That's good news for investors looking to take advantage of higher rates.

The bad news is that rising borrowing costs can eat into corporate profits. With short-term rates near zero from March 2020 through the end of 2021, bank loan issuers enjoyed relatively low borrowing costs, but with the Federal Reserve aggressively hiking rates that's no longer the case.

The chart below illustrates an example. The blue line is SOFR, a rate that some bank loan coupon rates are referenced to, while the dotted red line is the market's expectation for the path of the fed funds rate. If you consider an average spread of roughly 3.5%, the average bank loan coupon rate was roughly 3.75% for most of 2020 and 2021. The markets are pricing in a peak fed funds rate of roughly 4.7%, meaning average interest expense in 2023 could be more than double what they were in 2021. That's a big hit for companies that tend to have volatile cash flows and weak balance sheets.

One of the reasons why we believe that recession risk is high is due to the aggressive pace of Fed rate hikes. As borrowing costs rise, that effectively makes the cost of money more expensive, slows down consumer spending, and should ultimately slow economic growth even more.

Over time, bank loan total returns relative to short-term Treasuries have been strongest when the yield curve is steep. As the curve flattens, and ultimately inverts, the relative returns have historically deteriorated. The table below compares the median 12-month total return of the Morningstar LSTA Leveraged Loan Index relative to the Bloomberg U.S. Treasury 1-5 Year Index, depending on the starting slope of the two-year/10-year yield curve. When the slope is below zero as it is today, the median relative return has been negative.

Here we show a different Treasury slope—the three-month/10-year Treasury slope—and we see similar results. When the yield curve is flat or inverted, bank loans don't tend to perform too well. The three-month/10-year Treasury curve is currently positive at 25 basis points, but we expect it to invert soon as the Fed continues to aggressively hike rates.

Bank loan prices are down for the year but are only slightly below the 10-year average. There have been a few instances since 2010 where prices fell below the current levels, either driven by economic growth concerns or stock market volatility. With the risk of recession on the rise, prices may resume their downward trend.  Prices might not necessarily reach the March 2020, pandemic-induced lows, but re-testing the 2011 or 2015 lows is possible.

Keep in mind that a return to the 2011 or 2015 lows wouldn't necessarily be disastrous as those prices are only 5% or so lower than the current price. When you factor in the high coupon rates that bank loans offer, total returns over a 12-month horizon could still be positive. But with risks high today, we'd rather wait for a better entry point.

There may be better entry points into the bank loan market down the road. While their interest rate risk has helped cushion them from sharper price declines this year, we believe credit risk will drive returns over the next six to 12 months.

With risk of recession high and corporate defaults likely to pick up, prices may fall modestly in the near-term. The high yields that bank loans offer can help offset some of those price declines over longer investing horizons, but over the short-run total returns may be negative.

If bank loan prices do fall as we expect, then the entry point may become more attractive. Since bank loans can generally only be held by large, institutional investors, mutual funds or exchange-traded funds (ETFs) tend to be the most appropriate way to gain exposure. Schwab clients considering bank loan funds can explore Schwab's Mutual Fund Select List or explore bank loan ETFs through the ETF Screener. When searching for bank loan funds, first start in the "Taxable Bond" category, and then search for "Bank Loan" under the Morningstar Category.