Fri, 6 Sep 2013
Although defaults are decreasing and fund inflows are increasing, bank loans carry significant credit risk and illiquidity compared with other fixed-income vehicles.
Christine Benz: Hi. I'm Christine Benz for Morningstar.com. Investors have been gravitating to bank-loan funds because of their lack of interest-rate sensitivity, but the funds still have plenty of risks. I recently sat down with [Morningstar's] Tim Strauts and Sarah Bush, both bank loan-fund analysts, to discuss some of the pros and cons of the bank-loan fund category.
Let's discuss the pros and cons of bank-loan investments. Sarah, one of the things that investors have really been attracted to recently is the idea that they'll have some imperviousness to interest-rate hikes down the line. Let's talk about how that works, and why that is widely viewed as one of the big attractions of these investments.
Sarah Bush: It's really understandable that with people being concerned about rising interest rates and seeing what we saw earlier in the spring and early summer, that bank loans will be interesting to investors. Bank loans basically reset to a spread over LIBOR periodically. There's almost no interest-rate risk in these portfolios. That's something I think is very attractive to investors. However, it is one thing to remember that these are adjusting over short-term rates, and short-term rates have been relatively low and are expected to stay pretty low for a while. If you see the [10-year Treasury rate] move up, you're not going to see an immediate jump in yield on your bank-loan fund.
Benz: In this recent jump up with interest rates in sort of that May/June period, how did bank loans perform?
Bush: They did pretty well. There were a little bit of losses within the category, but nothing like what you were seeing in other types of fixed-income asset classes.
Benz: One of the big risks of bank-loan funds, which we'll get to later, is their credit sensitivity. But, Tim, you noted in a recent article that actually default rates in the bank-loan space have improved quite a bit recently. Let's talk about that.
Tim Strauts: Because the economy has been doing pretty well. Everyone talks about the economy; we'd all love to have 3%-4% gross domestic product growth rates. But we don't need that in bank loans to be successful. We just need positive, slowly improving growth, and that's kind of what we have seen. The latest default numbers are looking in the low 1.0%-1.5% range. Historically, they've typically averaged around 3.0%. We're at about half of the default levels we've seen historically. That's just due to the improving economy we're seeing.
Benz: Tim, you also noted that the ownership characteristics, who's owning bank-loan funds and bank-loan investments, has improved. That in the past, there was a lot of hedge fund activity in that area, and that sparked a mass exodus out of the loans in 2008. How has the composition of ownership in the bank-loan space changed, and how do you think that's a benefit for investors?
Strauts: Well, if we look back to the 2007 period, back then about 27% of the bank-loan market was owned by hedge funds, and hedge funds don't buy things and just own them. They tend to leverage the portfolios by 3, 4, 5 times [their values]. When the crisis hit in 2008, you had bank-loan portfolios, which were leveraged up, and so as the prices started falling, the hedge funds were taking a magnified losses on the downside.
They were massively selling their portfolios, exacerbating the declines in the bank-loan space. Today, the hedge funds are only about 9% of the market. So it's a much lower portion. And we're seeing there are a lot more retail investors filling the gap for those hedge fund investors, and we're seeing very strong flows recently.
Benz: Sarah, as Tim alluded to, and as we've discussed, there is a significant amount of credit risk baked into some of these loans. Let's talk about what investors should be thinking about as they try to get their arms around the risks of bank-loan investments. How should they think about a bank-loan fund in the context of a broader bond portfolio?
Bush: I think there are a couple of ways to think about it, and I've mentioned several times that there's a lot of overlap between bank loans and high-yield bonds. You might think of this as sort of at the higher-quality end of, say, a high-yield portfolio because of these protections that bank loans have. Another place that we've interestingly heard people using [bank loans] is sort of as an inflation protection because if you have interest rates rising along with inflation, you don't have a problem in terms of taking principal losses. The companies in these markets are economically sensitive. They should do well in that environment, so you should see credit improvement.
Strauts: I think that bank loans should be used maybe as an alternative to high-yield because when we look at the relative yield--high yield maybe gets you 5.5% or 6.0% depending on the fund and how much risk its taking. Bank loans are paying in the 4.0%-4.5% range, so you are getting a lower yield. But you get a floating-rate yield that could rise when short-term rates rise, and that is secured by collateral. The bank loans are higher in the capital structure than high-yield bonds. So it can be a nice trade-off from high yield. I think what we're going to talk about next is about the flows, and I think a lot of people maybe aren't selling high yield and going to bank loans. They are selling their government-bond portfolio and going to bank loans, and that's where the risk comes in.
Bush: I think we always talk about one of the concerns, and I think in the past people have viewed this as a cash or money market substitute. They see that there is no interest-rate risk. However, there is still plenty of risk, so we need to be real clear that this is not cash or a short-term high-quality substitute.
Benz: Think of it as a more aggressive part of your bond portfolio.
Benz: I would like to look at the flows going into the category and also the potential impact on liquidity in this area, or whether there are risks for investors because of all of these dramatic flows that we've seen recently. Sarah, what's your take on that question? Should investors be concerned because there has been such enthusiasm for the category?
Bush: Yes, I certainly think that treading carefully is important at this point in the market. Any time you see huge flows into an asset class--and especially one where I think a lot of the borrowers are looking at this environment and thinking we can get really good terms, we can get really good pricing--that's going to mean that you're not getting quite as an attractive a deal as an investor.
Benz: There is so much demand that people think this is a good time to issue these.
Bush: Exactly, and you're starting to see more pressure on prices, so you're getting paid less yield for the same kind of credit risk. Then also the kinds of packages that are protections for borrowers in these loans, which is part of the attraction of the asset class, they're getting a little bit weaker. And that's something you expect to see through a credit cycle when you see this, and especially when you see this type of interest in the category.
Benz: Another potential concern is what could happen if things don't play out as some investors seem to be expecting, and in fact, we do have some sort of credit shock or some sort of sense of economic weakness. Tim, is there a risk that a lot of these dollars could flow out of bank loans just as quickly as they've gone in, and that could leave investors who are long-term in bank-loan investments holding the bag?
Strauts: That is definitely a concern, especially because bank loans are one of the most illiquid areas of the bond market. The liquidity has improved in the last, say, 10 years, but still you can't trade a bank loan the same way you can trade a Treasury bond. As investor flows come in, they can leave just as quickly. But one of the issues with investors leaving is that with bank loans the settlement process is seven days. If the fund sells a bank loan, it takes them seven days to receive the cash.
For most mutual fund buyers or exchange-traded fund buyers, the mutual funds and ETFs settle in three days. There is a mismatch between the settlement of the fund and the settlement of the underlying securities. So the fund has to fill that gap between seven and three. Most of the funds have credit facilities, so they can gain access to a credit line, if they need to, if there are large redemptions. The effect this has is essentially your fund can, for a short period time, be slightly leveraged because you can leverage the portfolio up for a few days.
Also sometimes the funds will own things that are not necessarily bank loans. They'll own high-yield bonds for a small sleeve of the portfolio, which settle in three days. There is this concern about massive redemptions. Obviously, it's not a concern right now, because we have massive inflows. But this would be more [of a concern a] year from now if the market turns.