If rates rise, bank loans might offer investors some downside protection, says Morningstar's Sumit Desai, but beware of credit risk.
Sumit Desai: Bank loan funds may be uniquely positioned to provide investors with some protection in a rising rate environment. As a reminder, bank loans are higher in the capital structure compared to traditional corporate bonds and are also secured by assets of the issuing firm, whereas bonds are typically unsecured. However, like high-yield bonds, bank loans are usually issued by below-investment-grade companies, so credit risk is still high, and returns typically display a higher correlation to equities than traditionally safe-haven bonds like Treasuries.
There's a case to be made that bank loans can help insulate investors from the price declines that traditional bonds would experience when rates rise. The interest paid by bank loans is determined in part by short-term Libor rates, and the floating-rate nature of these loans means that income payments should actually increase when that key interest rate rises.
Most bank loans have a Libor floor of around 1% that this rate must surpass before income payments start adjusting upward. Ninety-day Libor rates have spent most of the past few years below 50 basis points, however recent money market reforms have caused this rate to increase drastically over the past year, to around 85 basis points as of mid-September.
If the economy remains strong enough that the Federal Reserve raises rates, or if Libor rates surpass the 1% Libor floor present in most loans' terms, bank loans may provide some downside protection relative to other, more interest-rate-sensitive fixed-income sectors.
