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By Christine Benz | 08-21-2013 02:00 PM

The Basics of Bank Loans

Morningstar's Sarah Bush and Tim Strauts discuss what bank loans are, their credit sensitivity, reasons for loan issuance, and more.

Christine Benz: Hi. I’m Christine Benz for Morningstar.com. Bank-loan funds have grown by leaps and bounds in recent years, but the securities may still be unfamiliar to some investors. I recently sat down with two of Morningstar’s bank-loan fund specialists, Sarah Bush and Tim Strauts, for an overview of the group.

I’d like to start with the basics here, let's talk about what bank loans are. Sarah, maybe you can take this one. Talk about what bank loans are and how they differ from bonds?

Sarah Bush: Bank loans are what they sound like. They’re loans made to companies to help them finance mergers and acquisitions or sometimes for refinancing purposes. Typically, they’re made to a company, and then they’re syndicated out to institutional investors. Mutual funds can also buy them in that situation.

In terms of how they differ from bonds, the bank loans that we look at are floating-rate, so I think we’ll talk about that in a little bit more detail later. They are higher in the capital structure than a high-yield bond would be. If you have high-yield bonds and bank loans with the same company and there is some kind of problem, such as a default, you’re typically going to see higher recovery rates, a better investor experience, in the bank-loan part of the capital structure.

Benz: Tim, let’s talk about when companies will want to go out and seek a bank loan. What type of company would do that, and why?

Tim Strauts: I think the biggest example we see is in the leveraged-buyout area, where we see mergers and acquisitions. You see a private equity firm buy out a company, and they add lots of debt to that company. That debt often times is actually a bank loan, and so the reason they do it is because it's relatively low-cost financing. [Because it has a] floating rate, you may think that could be a bad thing for the issuer, they're not intending to have this bank loan out there for 10 years. It's meant to be a few years, and oftentimes you’re going to have lower rates than you could offer in fixed-rate debt. Typically it’s the leverage buyouts or just any other distressed company that’s looking for financing and maybe doesn't want to pay the higher fixed rates that a fixed-rate bond would cost.

Benz: Sarah, when you look across sectors, do you notice that bank-loan issuance tends to cluster in any certain sectors, or is it pretty well-dispersed across industries?

Bush: Yes, you see a lot of disbursal across industries. Health care is a big industry that we see bank-loan issuance in, but I think that’s 10% or 11% of the market. Services is another area that you see a fair amount of issuance.

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