November 7, 2018
Bank loans (also known as “leveraged loans”) have become an increasingly popular investment choice in recent years due to relatively high yields, low sensitivity to rising interest rates and strong performance in the current credit cycle. However, deteriorating loan quality relative to history, and also when compared to high yield bonds, may warrant investor caution. In our view, risks are rising in high-yield and bank loan investment strategies. Investors should exercise moderation when implementing these strategies, especially if they are used at the expense of high-quality, lower credit risk fixed income investments, such as U.S. Treasuries, which typically provide better defensive characteristics for diversified portfolios.
Advantages and risks of bank loans
Unique and changing characteristics of bank loans are important factors to consider.
- Floating rate features are likely to continue acting as a tailwind to loans. Bank loans tend to be floating rate in nature, which can provide potential advantages in rising interest rate environments when compared to traditional fixed interest rate bonds. We expect this tailwind to continue due to our expectation for interest rates in the coming year. For every 1 percent increase in interest rates, we anticipate that the price of loans will drop by 0.2 percent to 0.3 percent when compared to high yield bonds of a similar maturity (which we believe are likely to lose around 4 percent in price).
- Loan quality has deteriorated relative to high yield bonds. Bank loans are often senior in issuers’ capital structure, meaning they are amongst the top priorities for repayment in a bankruptcy, and often have a first lien on assets as collateral for the loan. This is one reason why bank loans have historically represented a lower risk, though lower return alternative, to high yield bonds. Declining loan covenant quality and reduced subordination over the past several years has eroded investor protections. As a result, average bank loan credit ratings have deteriorated relative to high yield bonds, and rating agencies have begun to raise concerns. According to Moody’s credit rating agency, “[Weaker] credit agreements are creating the potential to upend or dilute the position of first-lien loans at the top of the capital structure.”
- Riskier use of loan proceeds is a cautionary flag. On a year-to-date basis, 52 percent of the use of proceeds from bank loan issuance was for higher-risk activities, such as mergers and acquisitions (M&A) or leveraged buyouts (LBO). In contrast, only 19 percent of recent high yield bond issuance has been for M&A or LBO purposes while 79 percent has been for refinancing maturing debt or general corporate use. In times of market stress, companies that have used debt for core business needs instead of growth or expansion have typically fared better.
- High yield and bank loan yield spreads to Treasuries are tight by historical measures. The incremental yield received by high yield bond and bank loan investors is well below median levels over a range of various time frames. This indicates repricing risk if investor sentiment or the economic environment deteriorates. While the economic backdrop continues to be supportive and defaults remain low for now, we urge avoiding overreliance on lower-quality securities when valuations are rich by historical measures.
We believe that the primary component of fixed income portfolios should be comprised of bonds with low credit risk and strong portfolio diversification properties, such as U.S. Treasuries and high grade corporate or municipal bonds. Growing risks in the loan market warrant caution, despite strong recent performance. Rich valuations indicate bank loans and high yield bonds should be utilized in moderation. Our positioning remains neutral, with a cautious bias on the high-yield category (which includes bank loans). If you have questions or need additional information, please talk to your advisor.
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This information represents the opinion of U.S. Bank Wealth Management. The views are subject to change at any time based on market or other conditions and are current as of the date indicated on the materials. This is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. Any organizations mentioned in this commentary are not affiliated or associated with U.S. Bank in any way.
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Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio.
Diversification and asset allocation do not guarantee returns or protect against losses.
Past performance is no guarantee of future results. Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer's ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issues of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes.
- Bank loan market: Also known as “leveraged loan market,” comprises debt from companies with below investment grade credit ratings. Bank loans are typically secured with a lien on the company’s assets.
- Leveraged buyout (LBO): The acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company.
- Mergers and acquisitions (M&A): A general term that refers to the consolidation of companies or assets through various types of financial transactions. M&A can include a number of different transactions, such as mergers, acquisitions, consolidations, tender offers, purchase of assets and management acquisitions.