(PUB) Investing 2016

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These are interesting times for bank-loan portfolio man-
agers. Bank-loan funds have proved to be especially
prone to whipsawing views about the path of interest
rates. Like high-yield bonds, bank loans are usually
issued by below-investment-grade companies, so credit
risk is still high, and returns typically display a higher
correlation to equities than traditionally safe-haven
bonds like Treasuries. If the economy is weak or
in recession, this asset class may not perform well. For
example, the bank-loan Morningstar Category
fell 29.8% in 2008 (it also surged by 41.8% in 2009).
However, bank loans are higher in the capital struc-
ture compared with traditional corporate bonds
and are also secured by assets of the issuing firm,
whereas bonds are typically unsecured. So, in the
event of bankruptcy, bank loans come first, thus
making them safer bets with regard to credit risk.
This means that bank loans should hold up rela-
tively well compared with corporate bonds in the
case of a default or general economic weakness
(but losses can still occur).
There’s still a strong case that bank loans, also referred
to as floating-rate loans, can help insulate investors
from the price declines that traditional bonds would
experience when rates rise. The interest paid by
bank loans is determined in part by Libor rates (typi-
cally between 30–90 day Libor, depending on the indi-
vidual loan), and the floating-rate nature of these
loans means that income payments should actually
increase when that key interest rate rises. There is a
catch, though: Libor floors. Most bank loans issued
post-financial crisis include a floor, around 1% on
average across all outstanding bank-loan issues, that
three-month Libor rates must surpass before income
payments adjust upward.
Despite these seemingly attractive qualities, investors
have fled the category en masse over the past
two years. Bank loans gained attention in 2013 when
former Federal Reserve chairman Ben Bernanke
suggested rates could increase following the end of
the Fed’s quantitative-easing program. Following
this “taper tantrum,” assets under management in the
bank-loan category doubled from $75 billion at
the start of 2013 to almost $150 billion by March 2014.
Since then, investor sentiment toward the category
has faded, and persistent outflows caused category-
wide assets to plunge back to just $89 billion at
the end of June 2016.
However, a shift in interest-rate expectations likely
played a larger role in driving outflows. Longer-term
rates, like 10- and 30-year Treasury yields, have
surprisingly declined despite Bernanke’s proclamation.
Shorter-term rates, like the three-month Libor rate
that bank-loan interest is indexed to, have increased
lately (to 0.74%), but this important interest rate
still remains well below 1% Libor floors, so income
payments have yet to adjust upward. The Federal
Reserve has regularly indicated a desire to increase
rates but has yet to follow through because of uncer-
tainty in the global economy, which has worked
against bank-loan funds. Liquidity is particularly trou-
bling for bank loans because of archaic trading tradi-
tions that cause settlement times (the time between
when a manager sells a loan and receives cash for it)
to increase to as long as 14 days, if not longer. This
liquidity dynamic is the primary reason Morningstar’s
bank-loan category does not have any funds with
a Morningstar Analyst Rating higher than Bronze.
In the current economic environment, where growth
is stable but not strong enough for the Fed to raise
rates, it’s possible that high-yield bonds may continue
to outperform bank loans. Over the trailing five-year
period ended June 30, 2016, the bank-loan category
returned an annualized 3.3%, while the high-yield
bond category returned 4.6%. However, if the economy
is strong enough that three-month Libor rates
surpass the 1% Libor floor present with most loans,
bank loans may provide some downside protection
relative to other, more interest-rate-sensitive fixed-
income areas. K
Contact Sumit Desai at
Bank-Loan Funds Feel the Heat
Income Strategist | Sumit Desai