Can Bank Loan Funds Float to a Narrow Outcome?

 

January 18, 2017 [Bonds, Bank loans, laddering]
Jeff Klingelhofer, CFA


While bank loans offer protection from rising risk-free rates, they’re callable and frequently redeemed by the issuer in an improving credit environment, when they generally underperform high-yield bonds. But in a deteriorating environment, they drop about the same as high-yield bonds. They can overcome that negative skew, but only rarely.

Many investors might see bank loans as “fixed income” without duration risk, given their floating-rate structure. They may use them as a way to reduce their exposure to rising risk-free rates without moving out of fixed income entirely. While it is true that bank loans are mostly insulated from a rise in Treasury rates, investors going heavily into them are exposed to a number of other pitfalls.

First, bank loans are merely floating-rate high yield. That is, they have significant credit exposure and potential for loss during “risk off” environments. Second, bank loans are usually callable at the option of the issuer: when things get better, rather than appreciating in price, the bond is called back and the investor receives cash. From a total return perspective, generally the outcome in risk-off environments is bank loans and high yield both go down about the same amount, while in risk-on environments, high yield generally outperforms. This is a negative skew that is not favorable to bank loans in many environments. That said, bank loans certainly do have merits. They are another tool in the toolbox to help us achieve our objectives. They are another form of corporate credit and can be attractive relative to investment-grade and high-yield bonds at certain times.

To be sure, in an environment of rising risk-free rates bank loans do have the clear advantage of being floating-rate instruments. However, given the aforementioned negative skew in credit environments, and the positive skew amid rising Treasury rates, investors in pure bank loan products are betting on a very narrow outcome: rising rates without a corollary tightening in credit spreads, which is a rare occurrence. As there is no free lunch in investing, having a broad toolbox of instruments is a much better than investing in a narrow product dependent on a specific set of circumstances.

We find an actively managed laddered approach works consistently well in a rising rate environment. That said, we currently favor high cash positions and significant front-end paper that we can reinvest into a rising rate environment. While some “duration” has become more interesting following the U.S. elections, we currently do not find rates very attractive and thus generally remain defensively positioned.

It is important to remember that the world often experiences unexpected outcomes. Brexit, the U.S. election, the margin of loss in Italy’s failed constitutional referendum. Making explicit bets on such events is risky, and more akin to gambling than to calculated positions in discrete securities based on detailed appraisal of the issuer’s financial strengths and prospects. For several years running, after all, rates were supposed to have risen as developed economies took off following major central bank asset purchases and rock-bottom, or negative, key interest rates. But for the most part, they haven’t yet.

We aim to structure portfolios that can perform across many outcomes, adding risk exposures when the compensation becomes attractive or reducing them when compensation is poor. We think that for traditional fixed income, this approach has and will continue to perform well across the myriad of potential outcomes. By adding a pure bank loan product, one is making a bet on a narrow outcome while giving up the defensive characteristics that fixed income often provides.

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