Bond investors who have been pouring money into bank loans through mutual funds and ETFs may be surprised to learn that their growing popularity has increased their investment risks.
Bank loans, which are high-yield loans from banks to high-risk corporate borrowers and also known as leveraged loans, are callable. Their growing popularity among investors attracted to their adjustable rates has driven down credit spreads and yields, allowing borrowers to refinance at lower rates, according to AllianceBernstein bond strategists.
Seventy-three percent of outstanding bank loans were refinanced or repriced in 2017 — i.e. “called” — and the refinancing continued through midyear, driving down the dividend income of bank loan ETFs and mutual funds.
Although bank loan performance rebounded this year, that is not expected to last. “Bank loans tend to do best in the late stages of the credit cycle, when interest rates are rising and growth is still strong,” write Douglas Peebles, chief investment officer of fixed income at AllianceBernstein, and Gershon Distenfeld, co-head of the firm’s fixed income division, in a recent report on these loans. “When the cycle turns, growth slows and [their] defaults rise.”
S&P Global Ratings issued a similar warning in April. “History shows us that the worst debt transactions are done at the best of times. So, with the global economy strengthening in a near synchronized manner, now is the perfect time to be cautious.”
Peebles and Distenfeld write that bank loans are likely to perform worse than they did during previous cycle turns because of relatively poor credit quality. “Strong demand has been promoting lax lending and sketchy supply.”
Today’s bank loans, whose market tops $1 trillion, lack strong credit protections known as covenants, which traditionally provided bank loans better downside protection than bonds. About 75% of current bank loans have “covenant-lite” protection compared with less than 20% before the global financial crisis, according to Peebles and Distenfeld.
They expect bank loans will underperform high-yield bonds when the cycle turns, based on historic performance. In the months between January 1992 and June 2018 when the average price of bank loans was $88 or lower, bank loans returned an average 12.1% over the next two years but high-yield bonds did close to twice as well, up 20.5%, write Peebles and Distenfeld.
They recommend that investors now focus more on credit risk rather than rising rates and gradually move away from bank loans as rates continue to rise toward interest-rate sensitive assets such as U.S. Treasuries as other high-quality government debt. Once higher rates slow economic growth and the prices of credit assets decline, they recommend a barbell strategy using intermediate-term Treasuries and high-yield bonds.
For investors still wanting floating rate exposure, Peebles and Distenfeld recommend credit-risk-sharing transactions (CRTs), a type of mortgage-backed security issued by U.S. federal housing agencies, rather than bank loans because CRTs are not continuously callable.