Bank Loans Beat High Yield Amid Rising Rates? Don’t Bank on It

 

June 29, 2017 [Bank Loans, fixed income, yield, levered loans]
Christian Hoffmann, CFA


Bank loan products are often seen as a nice alternative to high yield in a rising interest rate environment, but the conventional wisdom about their interest rate protection and security needs a credit check.

 

Bank loan funds have been widely touted as a great way to help fixed income investors ride out a rising interest rate cycle. Also known as levered loan or senior loan funds, they are, after all, high yielding but with a variable rate. So, in theory, they not only provide elevated income but can also avoid the interest rate risk to which fixed rate bonds are subject (bond prices and yields move in inverse directions). What’s not to like? Especially now that the Federal Reserve is in tightening mode and increasing short term rates. The only problem is that the theory isn’t borne out in practice.

As Figure 1 shows, since the Fed first initiated its tightening cycle in December 2015, high yield has vastly outperformed the return of bank loans.

 

Figure 1 | Levered Loan Returns Coming Up Short vs High Yield Amid Current Fed Tightening 12/14/2015 - 6/27/2017

Source: Bloomberg

 

A handful of factors can explain the divergence in performance. Rising short-term rates typically coincide with an improving macroeconomic environment, which can actually be favorable for non-investment grade credit products. The rising economic tide tends to keep default rates low via favorable business conditions. It is worth noting that in such an environment, levered loans have almost no upside potential, given that they usually have limited or no call protection—so as spreads tighten, companies refinance at lower spreads. To put it in terms of upside/downside, leveraged loans generally have 0-to-1 points of potential upside and 100 points of potential downside. But it should be noted that on average defaulted levered loans have tended to recover around 80 cents, which is superior relative to the average recovery on high yield unsecured bonds—though any one outcome could be materially better or worse than that.

Other issues also weigh on bank loan products. Although both high yield and levered loans are of lower credit quality, and bank loans generally come with first-lien security provisions, many bank loans are sourced from very small companies that could not support a bond offering—so the security is an enhancement, but in no way does it mean you cannot lose money. Moreover, liquidity is far more challenged for bank loans than bonds, with far fewer dealers trading them, longer timeframes to settle trades and opaque pricing transparency, which can negatively impact total return.

It is comforting but incorrect to believe that levered loans will always outperform in a rising rate environment and also incorrect to believe that levered loans will always outperform in a weak macro or weak market environment. Figure 1 demonstrates underperformance during the most recent rising rate environment. Figure 2 illustrates a lack of meaningful defensiveness during 2008, which is probably the best example of market and macro weakness we’ve experienced in the past twenty years or so

 

Figure 2 | Levered Loans Downside Vs High Yield 1/08/2008 - 3/31/2009

Source: Bloomberg

 

None of this is to say that levered loans are evil or terrible outright. The floating rate structure and security package are real structural enhancements, but need to be weighed against other less attractive structural and market considerations, as it is clear there are gives and takes. Investors in bank loan funds should be well aware that they aren’t the silver bullets that many believe.

 

Figure 3 | Levered Loans Upside Vs High Yield 1/31/2008 - 1/31/2017

Source: Bloomberg

 

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