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Should You Consider Floating-Rate Bank Loans Today?

With the potential for higher interest rates in the future, the bank-loan market still looks attractive.

Timothy Strauts, 07/24/2013

Back in October 2012, I wrote an article titled "Are Bank-Loan Funds Ready to Be Loved Again?" in which I discussed the potential benefits of bank-loan funds--particularly in the context of a period of rising interest rates. If you're unfamiliar with the bank-loan sector, take a peek at that article before reading on.

In my previous piece I noted that bank loans have tended to have low average default rates versus high-yield bonds, above-average yields, and very low duration (given that they pay floating rates), are negatively correlated to Treasury bonds, and have historically generated above-average returns in rising interest-rate environments. All of these features are still valid today.

While the key features of bank loans haven't changed much, the market environment today is quite different than it was just nine months ago. Since I last wrote about bank-loan funds, the yield on the 10-year United States Treasury bond has risen from 1.7% to about 2.5% today. Meanwhile, investors have been pouring money into bank-loan funds. How have these funds performed in this environment and what is the outlook for the future?

A Perfect Storm Hits Bank-Loan Land
The largest bank-loan exchange-traded fund, PowerShares Senior Loan Portfolio BKLN returned 3.8% from Oct. 10 to July 19. Meanwhile, Vanguard Total Bond Market ETF BND, which offers broad exposure to the investment-grade bond market, declined by 1.8% over the same period. Interest rates have ticked up over the past nine months as the economy has continued to gradually improve and, more recently, in response to the Federal Reserve's signal that it may reduce the pace of its bond purchases. During this span, BKLN has performed exactly as expected. Rising rates have had very little effect on the price of bank loans, given that their duration tends to be very near 0. And given that the economy has continued to improve, the default rate within the sector over the past year has been just 1.4%. To put that in historical perspective, the long-term average default rate for bank loans has been about 3% with an average recovery rate of 70% (that is, lenders have recovered an average of 70 cents on the dollar in the event of default). All in all, the past 10 months were exactly the sort of scenario in which one would expect bank loans to outperform the broader bond market.

The Eye of the Storm?
Despite their recent rise, interest rates are still near historical lows. Since 1962, the 10-year Treasury bond has had a yield greater than the current yield 96% of the time. Interest rates would have to rise much further to reach the historical average 6.6% yield on the 10-year Treasury. Most market participants don't expect rates to touch that level in the next few years, but the consensus is that rates will continue rising. The Congressional Budget Office projects the 10-year Treasury yield will reach 3.0% in 2015 and 3.8% in 2016. If the CBO's projections pan out, then bank loans remain well-positioned to outperform other fixed-income sectors.

Bank-loan funds have received record inflows in 2013. Since the end of June, $33 billion has been invested in the category. The five largest monthly inflows on record occurred over the past five months. There is clearly tremendous investor interest in the sector. But is this popularity a cause for concern?

These strong positive flows into retail funds began about a year ago. It appears retail investors are filling the void in the bank-loan market left by the demise of leveraged hedge funds. According to Standard and Poor's, 26.8% of the bank-loan market was owned by hedge funds in 2007. By the first quarter of 2013, only 9.1% of bank loans were owned by hedge funds. These hedge funds have tended to employ significant amounts of leverage to juice equitylike returns out of bank loans. In normal markets this can be a very profitable strategy, but when the bank-loan market started to sour during the financial crisis, the use of leverage magnified these hedge funds' losses. Many of these hedge funds received margin calls and were ultimately forced to liquidate their portfolios at fire-sale prices. I believe that broader ownership amongst nonleveraged retail investors is a positive development for the overall health of the bank loan market. Under "new ownership" small losses will be less likely to cause panicked selling in the retail market the way it did amongst hedge funds meeting margin calls.

Timothy Strauts is an ETF analyst at Morningstar.

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