Bank Loan Funds Aren’t Perfect, But They Rising Rates Protection

Bank loans, also known as leveraged or senior loans, are among the alternative fixed income assets advisors may want to consider in the current environment.

The reasoning is simple. Not only are bank loans shorter duration fare, but they are typically issued by non-investment grade companies, meaning there are potential credit opportunities in this segment. Undoubtedly, lower interest rate risk and an elevated income profile make for an enviable combination in any climate, including today’s.

Indeed, bank loans are proving durable against the backdrop of Federal Reserve tightening. The S&P/LSTA U.S. Leveraged Loan 100 Index is down 1.36% year-to-date --  a stellar showing relative to the almost 7% shed by the widely observed Bloomberg US Aggregate Bond Index.

The “secret sauce” with bank loans isn’t really a secret. It boils down to floating rate notes (FRNs). That’s how senior loans are structured, ensuring these bonds aren’t highly vulnerable rising interest rates.

Bank Loan Pros and Cons

Obviously, plenty of clients are going to be interested in bonds with limited rate risk and above-average income streams. Bank loans check those boxes, but that doesn’t mean they’re perfect and that lack of perfection isn’t confined to the point these are junk bonds.

“Beyond borrowers’ credit ratings, there are other important items to note when evaluating credit risk. First, the degree of protection from these loans’ seniority varies according to the size of subordinated bonds or loans below it,” says Morningstar analyst Lan Anh Tran. “The fewer of these subordinated tranches there are to absorb losses, the less seniority matters. Thus, recovery rates among loan-only borrowers are often lower than those among issuers with both loans and bonds in their capital structure.”

Another potential drawback is complexities involving the terms of these loans and the emergence of cove­nant-lite loans.

“This generally means that there are fewer terms in place to protect lenders. Most often that means forgoing maintenance covenants that subject borrowers to regular financial tests,” adds Tran. “This could reduce recovery rates in the event of a default. The prevalence of covenant-lite loans has increased in recent years, as loose lending markets have made the supply side of the market more competitive.”

Hard to Do Better

Again, bank loans aren’t perfect and it’s important to articulate as much to clients. Still, there are plenty of clients that are unaware of this asset class that upon hearing “low rate risk” and “high income” are likely to thank advisors. There are other perks, too.

“These loans also typically enjoy a more-senior position in their issuers’ capital structure relative to traditional bonds. They are often senior-secured, giving them claim to specific assets on the borrower’s balance sheet in the event of a default. These features improve the loans’ recovery rate in the event of default,” concludes Morningstar’s Tran.

Bottom line: Nothing is going to be perfect in the fixed income environment such as the one advisors and clients are dealing with today. Bank loans certainly aren’t free of flaws, but they are one of the better bond segments to consider today.

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