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.”