Investors consider category as higher quality than junk bonds
With record-low interest rates wreaking havoc on income-seeking investors and the risk of a rate increase growing with each passing day, floating-rate bank loans have become the latest darlings of bond investors.
A large part of the appeal, which was illustrated by nearly $15 billion pouring into bank loan mutual funds during the first quarter, is the idea that the interest on the loans adjusts to rising interest rates.
The interest on the loans, which are made to businesses by banks, is pegged to the London Interbank Offered Rate.
Although the bank loan category qualifies as below investment- grade, it generally is considered higher quality than traditional high-yield bonds, mainly because of the floating-rate feature.
“With bank loans, you don't have the inverse mathematical relationship between loan prices and rates because of the low duration of these loans,” said Jeff Bakalar, co-head of the $15.3 billion senior-loan group at ING Investment Management.
Bank loans have an average duration, as a gauge of sensitivity to interest rate movements, of 0.2.
By comparison, high-yield bonds have a duration of 5, and investment-grade bonds have a duration of more than 7.
This means that if long-term interest rates went up 1 percentage point, the value of a high-yield bond with a duration of 5 would fall by 5%.
The bank loan funds category, as tracked by Morningstar Inc., gained 9.4% last year and is up about 3.4% this year.
"MONETARY EXPERIMENT'
That compares with the Barclays Capital U.S. Aggregate Bond Index, which gained 4.2% last year and is down about 0.2% this year.
Although bank loan yields are comparable to those of other high-yield bonds, much of the recent appeal can be traced to the floating-rate component.
But that shouldn't be the only reason to invest in bank loans, according to Mark Okada, co-founder and chief investment officer at Highland Capital Management LP, an $18 billion asset management firm.
“It will be hard to call the exact move in interest rates, because we're in a massive global monetary experiment that's never been done before,” he said. “And anybody who tells you where rates are going, you shouldn't listen to — besides [Federal Reserve Board Chairman] Ben Bernanke.”
CLO FUNDS
Part of the reason that Mr. Okada likes bank loans has to do with something most people aren't even talking about. About two-thirds of the $1.3 trillion bank loan market is owned by collateralized-loan-obligation funds, which represent stability.
“The CLOs have 10 years to raise the money, so there's no hot money there,” Mr. Okada said. “And when the loan yields start to compress below 4%, the CLOs start to not be interested.”
In addition to the floor installed by the presence of the CLO market, bank loans also stack up strongly compared with traditional high-yield bonds when it comes to default risk.
The average high-yield bond is rated B, while the average bank loan is rated double-B.
In terms of historical default patterns, the long-term default rate of bank loans is 3%, with an average recovery rate of more than 70%.
High-yield bonds have a long-term average default rate of 4%, with an average recovery rate of 30%.
“Both have default risk, but it's better to be in bank loans than high-yield bonds if you adjust for default risk and recovery,” Mr. Okada said.
To be clear, bank loans are below-investment-grade bonds and should be approached accordingly, Mr. Bakalar said.
“It is a great asset class that is very well-positioned, but it is not without risk,” he said. “I wouldn't want to leave anyone with the impression that it's a turbocharged money market fund, because you can't get these kinds of spreads without taking credit risks.”
