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.
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.
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.
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