In a rising rate environment, it’s not surprising that investors are turning to bank loans. As AllianzGI Short Duration High Income Fund portfolio managers Jim Dudnick, CFA, and Steven Gish, CFA, explain, there is merit in this strategy.  Their fund invests in below-investment grade credits at the front end of the yield curve and can tactically allocate up to 20% in bank loans.  As investors look at leveraged loans, however, there are risks they should consider in this current market environment before they fully dive in.

Credit Risk

Throughout the business cycle, high yield bonds and bank loans provide superior coupon and return generating ability versus investment grade alternatives.  Benchmark driven approaches will benefit from the high coupon during years when the US economy is growing.  Conversely, in periods of slowing growth or even a recession, the most leveraged companies are at the most risk to price declines.  Managers that strategically select credits focusing on capital preservation not benchmarks may have the ability to side-step deteriorating credits.  Despite the senior secured position in the capital structure that bank loans typically hold, the economic sensitivity to the business cycle may provide greater credit risk versus a Short Duration High Yield fund that carefully invests in unsecured high yield debt at the front-end of the curve.

Repricing Risk

Effectively, when loans trade above par, issuers are highly motivated to reduce their interest expense since they most often do not have to pay a premium to reprice bank loan obligations. That premium is referred to as “call protection”.

If investors buy or even own loans above par, they run the “risk” of having their coupons or spread reduced and premiums evaporate as loans are often repaid at par. The bank loan asset class differs from the US corporate bond market in this “call protection” dynamic. Loans can be repriced relatively quickly after issuance without prepayment penalty since it is not customary for loans to have more than six months or one year of call protection (premium to par that equates to a cost an issuer must pay to lower their spread or fixed coupon of their debt).

Bonds are different. For example, our portfolio trading above par does not have the same risk as a bank loan portfolio. The vast majority of high yield bonds carry “call protection”. So if a company we are invested in wants to reduce the coupon, it is required to pay a premium according to the call schedule contracted at issuance. This is in contrast to a loan that could reprice one year after issuance without paying a premium above par, leaving the investor with a potential loss.

Careful attention to repricing risk for bank loans and high yield bonds should be considered in portfolio management of a strategy aimed to reduce drawdowns and pursue capital preservation.

Liquidity Risk

Unsecured high yield bonds trade with a regular settlement of T+3, which will improve to T+2 per SEC guidelines later this year. Bank loans generally settle on T+7 and frequently settle after the target settlement date.  Settlement can be extended due to changes in terms, resetting interest rates, or amendments to terms and conditions of loans.  During periods of market distress or price dislocation, settlement differentials in bank loans could present challenges for investors to redeem in a timely manner.

In reviewing some of the most dramatic moves in both equities and fixed income over 2016, the risk of attempting to transact in T+7 liquidity was apparent. The US election and Brexit were two of the most volatile events of the year that presented investors the opportunity to reassess their economic and political expectations for asset valuations and adjust their portfolios accordingly. If liquidity for a bank loan investment was only offered seven trading days after each event, investors may not have had the opportunity to redeem their bank loan investment to acquire risk assets or risk free assets depending on their interpretation of each event before the market fully priced in each respective event. Fortunately for the bank loan asset class, there has not been an event to date that has led investors to seek significant redemptions at T+1 liquidity in a variety of investment vehicles that offer it, including ETFs or ’40 ACT US mutual funds.

Consider Short Duration High Yield

Investing in bank loans in a well-diversified fixed income portfolio can make sense for some investors.  But before diving into the asset class, it’s important to consider some of the risks in today’ market environment.  AllianzGI Short Duration High Income Fund focuses on liquidity, reducing volatility, and positive total return and may be an attractive alternative to a pure investment in bank loans.

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Investors should consider the investment objectives, risks, charges and expenses of a mutual fund carefully before investing. This and other information is contained in the fund’s prospectus and summary prospectus, which may be obtained by contacting your financial advisor. Please read them carefully before you invest.

High-yield or “junk” bonds have lower credit ratings and involve a greater risk to principal. Derivative prices depend on the performance of an underlying asset; derivatives carry market, credit and liquidity risk. Bond prices will normally decline as interest rates rise. The impact may be greater with longer duration bonds. The market for certain securities may become illiquid, which could prevent the Fund from purchasing or selling these securities at an advantageous time or price and possibly delay redemptions of Fund shares.

The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Forecasts are inherently limited and should not be relied upon as an indicator of future results. References to specific secu­rities, issuers and market sectors are for illustrative purposes only. Nothing contained in this presentation constitutes an offer to sell, or the solicitation of an offer to buy or a recommendation to buy or sell any security; nor shall anything in this presentation be considered an offer or solicitation to provide services in any jurisdiction in which such offer or solicitation would be unlawful. The information provided is for informational purposes only and investors should determine for themselves whether a particular service or product is suitable for their invest­ment needs or should seek such professional advice for their particular situation. Past performance is not indic­ative of future results.  150653

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