The Case for Investing in the Bank Loan Market
Interest rates remain historically and persistently low, which has weighed on investor demand for floating rate assets, including leveraged loans (“bank loans”). Despite low interest rates, we believe bank loans can provide investors with attractive and differentiating qualities. In the current environment, we see a number of reasons to invest in the loan market: 1) Low rates ≠ low yields, 2) Valuations provide attractive compensation for credit risk, 3) Loans offer advantageous capital structure positioning from senior secured exposure, 4) Supply/Demand dynamics are supportive, and 5) Loans have historically offered superior risk-adjusted returns.
Bank loan coupons include two components: a short-term floating interest rate plus an additional “spread” that provides compensation for credit risk. While short-term rates are near historical lows, many bank loans include a floor on this component of the yield, providing support in a low rate environment. Currently, more than one-third of issuers have LIBOR floors in place (typically 1%) and we expect that number to trend higher as most new issues are coming to market with floors around 0.75-1% (Exhibit 1 & 2).
Bank loan spreads are near their recent historical highs, reflecting investor concerns about default risk given COVID-related economic weakness. While defaults are likely to rise, we believe current spreads significantly compensate investors for the actual credit risk in loans. As a result, we believe bank loans offer attractive overall yields and a compelling entry point, as improving economic growth may lead to lower spreads, creating the potential for capital gains for bank loan investors.
Historically, loans have experienced lower defaults and higher recoveries due to their senior position in the capital structure. Leveraged loans are typically secured by a first priority lien on the borrower’s assets making them first in line in the event of a bankruptcy. This drives reduced volatility and credit risk, especially during periods of market uncertainty. The loan market also has lower exposure to the energy sector than the high yield market. With elevated default volumes and near-zero recoveries in the energy sector, a smaller exposure to this sector provides a tailwind for the loan market.
Current supply/demand dynamics are supportive for loans. A lack of new supply has been a tailwind for performance in the secondary market. Issuance this year has been the slowest since 2012 and repayments have risen. As a result, net supply is down this year leading to a slowdown in growth of the market. On the demand side, collateralized loan obligations (CLOs) continue to grow as a source of demand for loans, helping to offset the continued, albeit moderating, outflows from the asset class. Additionally, we have been observing improvements in loan concessions, such as the presence of LIBOR floors discussed above, as well as original issue discounts (“OIDs”) and tighter documentation.
Loans have historically delivered superior risk-adjusted returns, having the highest Sharpe ratio over the last 10 years when compared to high yield, investment grade, 10-Year US Treasuries, and the S&P 500, which can be attributed to the asset class’ low price volatility. The presence and growth of CLOs in the market has been one of the biggest drivers of low volatility as CLOs create price stability in the loan market since they are largely buy and hold and incentivized to remain up-in-quality (Exhibit 3 & 4). Turning to the numerator, loans have historically outperformed high yield on an excess return basis during risk-off periods and tend to have lower correlation to other asset classes (Exhibit 5). Diversifying a portfolio with loan exposure therefore allows investors to swap into lower volatility while achieving potentially higher excess returns.