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RidgeWorth Report: Bank Loans Better Hedge as Rates Rise

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According to a June white paper released recently by RidgeWorth Investments, bank loans, or floating rate loans, as they are also called, are a worthwhile investment, particularly in a rising interest rate environment. Since they “have generally outpaced other fixed income sectors” when interest rates are on the way up, they can provide additional diversification within fixed-income portfolios for investors, according to report.

Bank loans are issued by corporations to raise capital. They are privately structured debt obligations that stand high in the capital structure of the corporation, “primarily composed of first lien and senior-secured debt” that will have to be paid before other financial obligations such as subordinated and unsecured debt and preferred or common stock in the instance of a bankruptcy or default by the corporation. They also frequently contain restrictive covenants to prevent a corporation from upsetting financial ratios by issuing more debt.

The prices of traditional fixed-rate bonds fall when interest rates rise, although of course when rates are falling the opposite occurs. Since rates have been so low for so long in an effort to stimulate the economy, RidgeWorth says that a recovery is likely to cause rates to head back up. This sets the scene for improved yields in portfolios holding floating rate loans.

Because bank loan coupons reset as interest rates rise, says the paper, “the sensitivity of a Bank Loan portfolio’s market value to changes in interest rates is small.” Citing also low correlation to other asset classes and lower-risk high yield exposure, the paper also explains that bank loans are “high in the capital structure” and so have a higher recovery rate if the economy drops, thus providing some downside risk mitigation.

While acknowledging that a “double-dip” recession due to current global economic problems, consumer skittishness, and continued high levels of unemployment could cause problems for corporations issuing bank loans and pave the way for increased business defaults, RidgeWorth makes the case that the default rates for bank loans have historically been lower than those for high-yield bonds. In 2009 and 2010, it acknowledges, both types of investments have seen about the same rate of default.