With nary a place to turn for yield in the current low-interest rate companies should consider bank loans to add a little zing to their fixed income portfolios and perhaps a little safety, too.
Investments in the leveraged bank loan market can be an attractive sub-asset class, or alternative investment, for corporate cash investors looking to diversify their fixed income portfolio, pick up yield, and reduce interest rate risk. Further diversification into the European leveraged loan market for some portion of a corporate’s allocation to this asset class is also worth consideration.
Generally speaking, there is more yield to be found in Europe, but more liquidity in the US, according to one expert. Vanessa Ritter, head of global loans for BNP Paribas Asset Management recently provided a bit of history on the bank loan market recently, comparing the US and European landscapes. The US market, she said, is about five times the size of the European market giving it more liquidity. However, companies in Europe tend to borrow via bank loans instead of issuing bonds, thus making loans an exclusive investment opportunity for global investors, Ms. Ritter noted.
The more established US leveraged loan market has grown steadily from around $73 billion in 1998 to over $600 billion in 2013. The European loan market is more nascent comparatively, and is roughly a fifth of the size at $140 billion, according to market data by S&P Capital IQ. However, the European market has started to grow more rapidly and there are increasing signs it could take off with growing demand for credit and a renewed appetite for lending despite continued reluctance by banks to hold loans on their books. This same trend has also prompted competition from high-yield bond issues in Europe, but leveraged loans have caught up, in part due to changes in covenants, allowing borrowers more “cov-lite” options. Cov-lite or covenant-lite loans are those issued with fewer restrictions on collateral, payment terms, and level of income. About 60 percent of new loans in the US are cov-lite, full covenant packages remain far more common in the European market.
Sources of attraction
What makes bank loan investments attractive is that, while leveraged, they are secured by the property, plant and equipment; in other words, the real assets of the borrowers underlying the CLO or credit fund pool. And while there is risk in the underlying borrowers as credits, this is offset by the real assets securing the loans.
Companies in every sector of the economy issue loans, including energy, industrials, services and healthcare, thus investors have the opportunity to diversify industry exposure within their loan portfolio. Bank loan investments pay equity-like returns, spreads on new issues can be 350-400bps over Libor/Euribor, but enjoy relatively low default risk (lately around 2 percent in the US, rising from near zero in 2011 vs. just under 3 percent in Europe, falling from over 6 percent toward the end of last year. The “senior” status refers to the positioning in the superior position in the capital structure, which allows for repayment before other claimants in the event of bankruptcy. Ms. Ritter reminded investors that despite the loans being senior-secured, investors should be selective about leverage ratios, maturity schedules, refinancing concentrations and other risk factors.
Here are a few other considerations investors should weigh when thinking about bank loans:
High Yield and Loans can both be in the investment portfolio. An investor does not have to pick or chose the high yield bond versus the loan market. Despite both carrying more credit risk than an investment grade corporate bond, the two can be looked at as complementary products. Bonds and loans trade in different markets and there is roughly only a 50 percent overlap between the high-yield bond and loan universe, so each asset class will contain unique issuers.
Less Interest-Rate Sensitive. As floating-rate instruments, bank loans also represent a potential hedge against risking interest-rate risk in your cash portfolio. At issuance a margin over Libor (Euribor for Europe) is set, with a “floor” rate. The floor is in effect until Libor exceeds this minimum level, after which the coupon rate is reset every three months at the then prevailing market rate.
Outlook for Loans. While pricing in the US has gone up, reflecting growing investor interest, a similar uptick has not been seen in the European leveraged loan market. This helps explain the growing number of investment advisors pitching Europe. For 2014, leveraged loan issuance in the US is expected to be strong and this should offset the increased demand.
Case for Considering Bank Loans – Move Beyond the Name. Delving further into their risk-return profile and correlation to returns other fixed income assets and equity, investors often find adding bank loans improves the overall risk-return profile of their portfolio. For the corporate cash investor, a little bit of operational work may be required initially. First, check with your custodian and determine with them their comfort level around pricing and accounting for bank loans. We know many corporate cash investors investing in this segment of the market, so it can be done. For those where the operational hurdle might not be worth the work for a smaller segment, a fund or some type of commingled option should be considered.
Leveraged loans should be considered in an investment portfolio that is looking for yield and diversification, and has the risk budget that allowed for a smaller component of “high yield” assets. Despite the scary name, especially European Leveraged Loans, these loans are securitized and senior in the capital structure. When considering this asset class, consider both US and European loans as each has a unique group of issuers and adding both can provide more diversification and yield.