A version of this article previously appeared in the March 2022 issue of ETF MorningstarInvestor. Click here to download a free copy.
On January 26, 2022, the Federal Reserve announced that it would likely raise interest rates in March. Stocks and bonds had been in the red since the beginning of the year and the prospect of higher rates did not help matters.
What can investors do to protect their portfolios from the pressure of rising rates? Reducing interest rate risk might be the easiest solution. And few options are as secure in reducing interest rate risk as bank loans.
It’s no surprise that many investors flocked to bank loan funds in 2022. Mutual funds and exchange-traded funds in the Morningstar bank loan category attracted nearly $9.6 billion in new flows in January, marking organic growth of 8.2% over their combined year. -active at the end of 2021.
Before following the crowd, investors should educate themselves on bank loans and funds investing in this space. If they can help prevent interest rate risk, they take others. Additionally, there are many implementation challenges that can either hinder the ability of these funds to successfully invest in the space or create opportunities for them to add value. Here, I will give investors an overview of what to look for when selecting bank loan funds from the menu.
Bank Loans 101
Bank loans, or leveraged loans, are private loans taken out by companies from banks or a syndicate of lenders. Borrowers often have credit ratings below investment grade. As such, they will often offer an additional return to offset their credit risk. Almost all bank loans have floating interest rates. Their coupon rates are calculated by adding a predetermined spread on a benchmark interest rate such as Libor or SOFR. These coupons reset regularly in response to market interest rate fluctuations, typically every 30 to 90 days. This floating rate feature significantly reduces their sensitivity to interest rate risk, making them an attractive asset when interest rates rise. These loans also generally benefit from a higher position in the capital structure of their issuers compared to traditional bonds. They are often secured first lien, which entitles them to specific assets on the borrower’s balance sheet in the event of default. These features improve the recovery rate of loans in the event of default.
From the borrowers’ perspective, issuing debentures to raise capital will likely mean paying its creditors higher interest rates. The capital structure of the issuers being higher and the backing to specific assets makes bank loans a means of borrowing at a relatively lower cost. Borrowing directly from financial institutions also allows companies to further customize the terms of their loans, allowing early repayment without incurring significant penalties, for example.
So what’s the catch?
There is no free lunch, and bank loans are no exception. In exchange for anything but immunity to interest rate risk, investors in bank loans assume considerable credit risk. Although the structures of these loans may improve recovery rates compared to more junior unsecured debt, the creditworthiness of borrowers and the quality of their assets will influence performance.
Beyond borrowers’ credit scores, there are other important things to note when assessing credit risk. First, the degree of seniority protection of these loans varies depending on the size of the subordinated bonds or lower loans. The fewer these subordinate tranches there are to absorb losses, the less seniority counts. Thus, recovery rates among borrowers who only borrow loans are often lower than those of issuers with both loans and bonds in their capital structure.
Second, the terms of the loan are important. In recent years, a large proportion of new senior loans have been covenant-lite. This usually means there are fewer conditions in place to protect lenders. More often than not, this means waiving maintenance clauses that subject borrowers to regular financial testing. This could reduce recovery rates in the event of default. The prevalence of relief loans has increased in recent years as flexible loan markets have made market supply more competitive. Investors might receive a higher return on covenant-lite loans, but this is compensation for taking on greater credit risk.
Beyond credit risk, liquidity risk also plays an important role in this market. These loans are traded over-the-counter and tend to be thinly traded, which makes them expensive to trade. And unlike most bonds, the settlement process for Senior Loans can be manual and time-consuming, typically taking between seven and 12 business days on average.
Barriers to implementation
The illiquidity of bank loans presents challenges for funds that invest in them, especially index funds. The long settlement periods for these loans are in contradiction with the daily liquidity needs of UCITS and ETFs. Bank loan fund managers have different ways to manage this mismatch. They can hold a portion of their portfolio in cash or liquid securities, expedite the settlement of lending transactions, and/or maintain a line of credit to draw on in the event of large withdrawals. The last measure is often a “Break glass in case of emergency” option. In practice, most bank loan portfolio managers use a combination of the first two. Large managers with strong counterparty relationships can often negotiate early settlement, although this is never guaranteed. More generally, bank loan portfolios often have cash holdings parked in highly liquid money market funds in order to meet daily redemption requests. Some will also invest a portion of their assets in relatively more liquid high yield bonds or preferred stocks. These sometimes come from the same issuers as those represented in the loan pocket of their wallets. While these securities may be more correlated to senior loans held by these funds, they will alter the risk profile of the funds compared to holding only bank loans, generally trading lower liquidity risk for interest rate risk and slightly higher credit.
Basic credit research is essential in this market. While the stock market is generally very efficient, quickly absorbing new information in prices, the loan market is not. For Senior Loans in particular, the prevalence of lower quality issuers and the complexity of loan terms provide ample opportunity for savvy managers to add value. At the end of February 2022, only two of the 62 funds in the bank loan category are index trackers. This speaks to the challenges of indexing in this illiquid and esoteric segment of the market. Invesco Senior Loan ETFs (BKLN), one of two indexed options, is backed by a benchmark that includes only the 100 largest issues in the market. While its benchmark design promotes liquidity and can prevent inordinate credit risk by omitting small borrowers, it also misses out on a significant portion of the overall investment opportunity. The other index tracker, Highland/iBoxx Senior Loan ETF (SNLN), puts in similar railings. This leaves plenty of opportunities for active managers to add value.
Active funds are probably better here
Active bank loan managers can explore pockets of opportunity that are beyond the reach of the pair of passive funds counted among their competitors. Experienced teams with a wide range of credit analysts can leverage solid credit research to identify potential discrepancies between loan prices and their fair value assessment. They can also make timely tactical allocations to seize opportunities or run away from problem loans. And there’s evidence that some savvy managers in this space have done just that. For example, T. Rowe Price Floating Rate (PRFRX)the only fund in the category with a Morningstar Gold analyst rating, has historically seen a default rate of 0.1% among loans in its portfolio, compared to around 2% for the S&P/LSTA Leveraged Loan Index.
Table 1 illustrates the relative growth of a $1 investment in the Bank Loans category index and several funds relative to the Bank Loans category average. BKLN’s underperformance reflects its struggle against a category dominated by more nimble active peers. It should be noted that even the best performing funds in the category lag behind the S&P/LSTA Leveraged Loan Index. In this case, the benchmark is not a fair comparison, as it is not directly investable and does not take into account implementation challenges or actual transaction costs, which would likely largely reduce the actual performance of any fund that has tried to track it.
Count bank loans as one of the few corners of the market where active management is not so much a choice as a necessity. Table 2 presents a sample of mutual funds and ETFs (assets and liabilities) that carry analyst ratings in this category. At this point, it should come as no surprise that our top-rated funds in this area are actively managed funds, combining strong teams and processes with a low-cost kicker.
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