Bank loan returns this year have been relatively low despite their more aggressive risk profile. Although short-term rates have risen, bank loan average coupon rates haven’t gone up lately.
Despite the disappointing performance, prices are still high, leaving little room for capital appreciation.
We believe investors should take a cautious approach, as returns may continue to be relatively low in the near-term.
Bank loans are a type corporate debt whose coupon payments are tied to short-term interest rates. Because their coupon rates are designed to float, bank loan investors should benefit from higher payments when short-term rates are rising, as they have been during the past two years. Unfortunately investors haven’t seen those benefits this year, as average bank loan coupon rates haven’t gotten the bump that usually comes along with a rise in their short-term benchmarks. And despite their high credit risk, bank loans have barely outperformed more conservative investments like U.S. Treasuries and investment-grade floating-rate notes. With coupon payments not rising as expected and recent performance relatively weak, we prefer a neutral allocation to bank loans, and would keep total return expectations relatively low.
Bank loans—the basics
Bank loans—also called “leveraged loans” or “senior loans”—are a type of corporate debt, but they have some important characteristics that investors need to be aware of:
- Secured. Bank loans are collateralized by a pledge of the issuer’s assets, like inventories or receivables. When an issuer defaults, for example, the value of the collateralized assets can be used to repay the bank loan before unsecured creditors are repaid.
- Sub-investment-grade ratings. Bank loans carry sub-investment grade ratings (also called “high-yield” or “junk” ratings), so they have a relatively aggressive risk profile. Keep that in mind, given the “secured” characteristic listed above. Secured doesn’t mean safe—issuers can and do default on bank loans.
- Liquidity. Bank loans tend to be illiquid. Rather than trading 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 them harder to sell, and can lead to price declines during periods of market volatility. And given the more private nature of bank loans, individual investors can generally only access the market through mutual funds or exchange-traded funds. While this may allow investors greater access to the market, the illiquidity of the underlying investments can lead to volatility in a bank loan fund’s price.
- Floating coupon rates. The coupons on most bank loans are based off a short-term benchmark interest rate, like the three-month London Interbank Offered Rate (LIBOR), plus a spread. The spread can be thought of as compensation for the risks that bank loans offer, like the risk of default. With corporate investments, lower credit ratings generally mean higher spreads, all else being equal.
While the floating coupon rate may seem appealing, as the Fed has boosted its benchmark rate three times since December 2016, it hasn’t translated into higher coupon payments for investors.
Short-term interest rates have risen, so why haven’t average bank loan coupon rates?
The coupon rates on most bank loans are based on 3-month LIBOR, which is highly correlated to the Fed funds rate. As the Fed hiked rates four times since December 2015, 3-month LIBOR has gradually increased as well.
Three-month LIBOR has been steadily rising
Source: Bloomberg, using daily data as of 11/13/2017. ICE LIBOR USD 3 Month (US0003 Index).
But the rise in LIBOR hasn’t translated to higher coupon rates. According to J.P. Morgan, while 3-month LIBOR rose by 34 basis points through the first nine months of the year, the average coupon rate of bank loans fell by 2 basis points.1 To put that into perspective, the average coupon rate of the Bloomberg Barclays US Floating-Rate Notes Index, an index of investment grade corporate floating-rate notes, rose by 40 basis points over that same time period, illustrating that not all floating-rate investments are created equally.
Refinancing activity has prevented average coupon rates from rising this year. Issuers have generally been able to redeem their outstanding loans and reissue new loans with lower spreads, ultimately offsetting the rise in bank loan reference rates.
For example, assume an issuer has a bank loan outstanding paying a coupon of 3-month LIBOR plus a spread of 350 basis points, or 3.5 percentage points. If investor demand for loans is strong, the price of the loan may rise above its par value. This may allow the issuer to refinance the loan at a lower spread above LIBOR—perhaps with a spread of 300 basis points, or 3 percentage points.
Investors hungry for higher yields have likely played a part in this trend. Over the past 12 months there have been nine months of net investor inflows to bank loan mutual funds and ETFs, compared to small outflows over the last three months. But the magnitude of the inflows dwarfs the outflows—roughly $25.7 billion flowed into bank loan funds from November 2016 through July 2017, while net outflows totaled $1.2 billion over the past three months.
While net flows have turned negative, they represent just a fraction of the prior months’ net inflows
Source: Morningstar Inc. Columns represent monthly net flows into mutual funds and ETFS categorized by Morningstar Inc. as "Bank Loan" from November 2016 through October 2017.
We’ll be keeping an eye on that trend—while outflows may prevent issuers from refinancing at lower spreads, it could lead to price declines down the road.
Falling coupons and flat prices have kept a lid on total returns
While average coupon rates have fallen, bank loan prices haven’t budged much. The average price of the S&P/LSTA Leveraged Loan 100 Index has remained in a very tight range lately, trading between $98.1 and $99.2 all year.2
Bank loan prices generally don’t rise much above their par values because they can be retired at any time by the issuer. The average price of the index hasn’t crossed the $100 threshold since before the financial crisis, and even before the crisis, the highest average price on record is $101.3.3 Given the relatively high starting price, returns going forward will likely be driven more by income payments rather than price increases.
The S&P/LSTA Leveraged Loan 100 Index historically hasn’t risen much above the $100 level
Source: Bloomberg. Monthly data as of 11/13/2017.
The combination of relatively flat prices and falling coupon rates has weighed on total returns this year. Through November 13, the total return of the S&P/LSTA Leveraged Loan 100 Index is just 2.7%, more in-line with conservative investments like Treasuries than with more aggressive investments like high-yield corporate bonds.
Bank loan returns have been low despite the high risks
Source: Bloomberg. Indexes represented are the Bloomberg Barclays U.S. Treasury Bond Index, Bloomberg Barclays U.S. Corporate Bond Index, Bloomberg Barclays U.S. Corporate High-Yield Bond Index, Bloomberg Barclays U.S. Floating-Rate Note Index, and the S&P/LSTA Leveraged Loan 100 Index. Total returns from 12/31/2016 through 11/13/2017. Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.
High prices and rising risks mean returns could be paltry going forward
We think the trend of relatively low returns may continue for a few key reasons:
High prices mean there’s little room for prices to rise much further, limiting the capital appreciation for bank loan mutual funds and ETFs.
The refinancing wave may continue, resulting in lower spreads that can offset any potential rise in LIBOR. By our calculations, more than 70% of the loans held in PowerShares Senior Loan Portfolio (BKLN) are priced above par, making it possible that the issuers may be able to refinance them with a new loan with a lower spread.4 This means that bank loan fund income payments might not rise much even if the Fed continues hiking rates.
Credit risks appear to be rising. We are concerned with the quality of the loans that have been issued lately, as covenant quality has been on the decline. A bond covenant is a set of terms, defined in the bond’s prospectus, which outlines what the issuing firm can or can’t do with regard to its debt. A positive covenant is something the issuer is required to do, such as maintaining a certain amount of liquid assets on its balance sheet. A negative covenant restricts the issuer from doing something, like limiting the amount of debt that it can issue.
According to our calculations, more than 60% of the loans in BKLN are considered covenant-lite.5 Meanwhile, 85% of loans issues in the second quarter of this year were considered covenant-lite—a record high.6 This means there are fewer and fewer protections put in place that can prevent loan issuers from embarking on activities that may be detrimental to their loan investors.
What to do now?
We suggest investors keep only a neutral allocation to bank loans in the current environment. We think that bank loan funds can be part of investors’ overall fixed income allocation, but in moderation. Bank loan funds should be considered part of the “aggressive income” portion of a fixed income portfolio, along with investments like high-yield bonds, preferred securities, or emerging market debt, to name a few. We generally recommend investors limit allocations to aggressive income investments to no more than 20% combined of their total allocation to fixed income. We’d manage the total return expectations for bank loans accordingly, given the high prices and potential for average coupon rates to stay relatively flat. Investors interested in investments that are more likely to benefit from higher short-term rates may want to consider investment-grade floating-rate notes or funds that hold them.
1 Source: AllianceBernstein, “Cracks are Deepening in Bank Loan Market,” October 23, 2017.
2 Year-to-date through November 16, 2017.
3 Data going back to January 2002.
4 ETF holdings data as of 11/13/2017. The bank loan market is not very transparent, so we use the PowerShares Senior Loan Portfolio (BKLN) as a proxy for the market. No mention of particular funds or fund families here should be construed as a recommendation or considered an offer to sell or a solicitation to buy any securities. You should not buy or sell any mutual fund investment without first considering whether it is appropriate for you based on your own particular situation.
5 According to Bloomberg, for a loan to be considered covenant-lite it does not contain financial maintenance covenants which need to be met periodically while the loan is active.
6 Source: AllianceBernstein, “Cracks are Deepening in Bank Loan Market,” October 23, 2017.