by Collin Martin, CFA, Fixed Income Strategist, Schwab Center For Financial Research
- Bank loan coupon rates are referenced to short-term interest rates, not long-term interest rates.
- While they are “senior and secured,” bank loans can still default. The loan default rate has been trending lower, however, after peaking in mid-2020.
- Bank loans are highly correlated to high-yield bonds and the U.S. equity market. Instances of stock market volatility are likely to result in bank loan volatility as well.
Bank loans offer some of the highest yields in the current interest rate environment. We believe their unique characteristics may prevent many investors from considering them, but it may be a mistake to overlook them.
Bank loans, also called “senior loans” or “leveraged loans,” are a type of corporate debt that have a few characteristics that differentiate them from traditional corporate bonds:
- Sub-investment-grade credit ratings. Bank loans tend to have sub-investment-grade credit ratings, also called “junk” or “high-yield” ratings. Junk ratings are those rated BB+ or below by Standard and Poor’s, or Ba1 or below by Moody’s Investors Services. A sub-investment-grade rating means that the issuer generally has a greater risk of default, so bank loans should always be considered aggressive investments.
- Floating coupon rates. Bank loan coupon rates are usually based on a short-term reference rate plus a spread. The short-term reference rate is usually the three-month London Interbank Offered Rate, or LIBOR, although that will likely change in the future as LIBOR is set to be retired in a few years. The spread above LIBOR is meant as compensation for the lenders. Since bank loans come with increased risk—keep in mind that they’re junk-rated—investors demand higher yields in case the issuer cannot make timely interest or principal payments.
- Secured by the issuer’s assets. Bank loans are secured, or collateralized, by the issuer’s assets, like inventory, plant, property, and/or equipment. They are senior in a company’s capital structure, meaning they rank above an issuer’s traditional unsecured bonds. Despite that secured status, bank loans should still be considered risky investments given the aforementioned junk ratings.
Bank loans also can be held only by institutional investors, meaning most investors can access the market only through a mutual fund or exchange-traded fund (ETF). But we’ve found that many individual investors do not hold bank loan funds, despite their potential for higher yields and total returns.
Consider this: The high-yield corporate bond market and the bank loan market are similar in size, and both consist of debt issued by “junk” rated corporations. Meanwhile, high-yield bond mutual funds and ETFs have over $305 billion in net assets, compared to just under $60 billion for bank loan funds.1
Given that discrepancy, investors looking for higher yields may consider bank loans, but in moderation given their aggressive risk profile. While we still see some risks ahead, we believe 2021 will be a smoother ride than 2020. Like most fixed income investments this year, we believe bank loan total returns will be driven more by coupon income than price appreciation.
It’s still important to put the risks into perspective, however. As the chart below illustrates, bank loans can suffer severe drawdowns during periods of market stress. In 2020, the S&P/LSTA Leveraged Loan 100 Index was still able to deliver a total return of 3.5%, but in the early stages of the pandemic, the index plunged nearly 23% in the matter of weeks.2
Higher yields come with higher risks
Source: Bloomberg. Yields as of 1/15/2021. Yield represents average yield-to-worst for all investments, except preferred securities and bank loans which represents yield-to-maturity. Yield to worst is a measure of the lowest possible yield that can be received on a bond that fully operates within the terms of its contract without defaulting. Worst rolling 12-month total returns are from 12/31/1989 through 12/31/2020 using monthly data. For illustrative purposes. Past performance is no guarantee of future results. Indexes representing the various asset classes are: High-Yield Corporates = the Bloomberg Barclays U.S. Corporate High-Yield Bond Index; Preferred Securities = ICE BofA Fixed Rate Preferred Securities Index; Bank Loans = S&P/LSTA Leveraged Loan 100 index; Investment-grade Corporates = Bloomberg Barclays U.S. Corporate Bond Index; Municipal Bonds = Bloomberg Barclays Municipal Bond Index; U.S. Aggregate Bond Index = Bloomberg Barclays U.S. Aggregate Bond Index; U.S. Treasuries = Bloomberg Barclays U.S. Treasury Index.
Three considerations for bank loan investors today
Before investing in bank loans it’s best to understand the ins and outs. These points below aren’t necessarily positive or negative for the market—they are just important details to be aware of so investors aren’t blindsided by potential performance.
1. Coupon rates are referenced to short-term interest rates, not long-term yields.
We believe there is a common misconception that bank loans benefit when “rates” are rising, because their coupon rates are floating.
Most bank loan coupon rates are referenced to 3-month LIBOR, and that rate is influenced by the federal funds rate. Movements in other bond yields, like the 10-year Treasury yield, generally do not have an impact on bank loan coupon rates. While the 10-year Treasury yield is up nearly 20 basis points already this year, the fed funds rate is still near zero, and is expected to remain anchored there until 2023 or potentially even later.
Meanwhile, there’s been a flurry of activity in the bank loan ETF market, where bank loan ETFs experienced a more than $900 million net inflow for the week ending January 8, 2021—the same week that the 10-year Treasury yield rose 20 basis points.3 While the headline of “rising Treasury yields” may have resulted in large inflows, bank loan coupon rates should not necessarily benefit by the rise in 10-year Treasury yields.
Bank loan coupon rates are unlikely to rise as long as short-term interest rates remain anchored
Source: Bloomberg, using weekly data as of 1/15/2021. ICE LIBOR USD 3 Month (US0003M Index) and US Generic Govt 10Yr (USGG10YR Index). Past performance is no guarantee of future results.
2. “Senior and secured” doesn’t mean safe. Bank loans can still default, despite the senior and secured status. The current environment is a great example—the trailing 12-month speculative grade loan default rate ended 2020 at 7.1%, slightly lower than its July 2020 peak of 7.5%. That’s the highest default rate since the 2008-2009 financial crisis.
The bank loan default rate surged in 2020
Source: Moody’s. “Default Trends—Global, December 2020 Default Report,” January 11, 2021.The trailing 12-month speculative grade loan default rate represents the percent of speculative grade loans that have defaulted as a percent of the rated loan universe.
Concerns about the potential spike in defaults were a key reason bank loan prices plunged in the first quarter of 2020. Luckily that surge appears to be in the rearview mirror today, as the loan default rate has now declined in each of the past 5 months. If the default rate continues to decline, that should help keep bank loan prices relatively supported.
3. Low interest rate risk does not mean low volatility. Bank loans generally have low average durations—a measure of interest rate sensitivity. Interest rate risk is the risk that a bond or loan’s price will fall as the result of rising interest rates. Bank loans’ floating coupon rates help bring their average durations near zero; because the coupon can adjust to changing market conditions, their prices don’t need to.
But that doesn’t mean bank loan prices are always stable. Given their low credit ratings, and greater likelihood of default as the chart above illustrates, their prices are driven more by corporate fundamentals, as well as the direction of “risk assets.”
Bank loans are highly correlated to both the high-yield corporate bond market and the stock market, while they have a negative correlation with U.S. Treasuries. This helps illustrate that bank loans are aggressive investments and their performance tends to follow the lead of risky investments like U.S. stocks or high-yield bonds—for better or for worse.
Bank loans are highly correlated with high-yield bonds and the S&P 500
Note: Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated. Correlations shown represent an equal-weighted average of the correlations of each asset class with the S&P 500 using weekly data during the 5-year period between 1/17/2016 and 1/15/2021.
Source: Schwab Center for Financial Research with data from Bloomberg. Indexes representing the investment types are: Bloomberg Barclays U.S. Aggregate Bond Index (LBUSTRUU Index), Bloomberg Barclays U.S. Corporate High-Yield Bond Index (LF98TRUU Index), Bloomberg Barclays U.S. Treasury Bond Index (LUATTRUU Index), S&P 500 Total Return Index (SPXT Index), and the S&P/LSTA Leveraged Loan 100 Index (SPBDLL Index). Diversification strategies do not ensure a profit and do not protect against losses in declining markets. Past performance is no guarantee of future results.
What to consider now
Bank loans appear to be an underappreciated type of fixed income investment, and investors looking for higher income opportunities may consider them as a complement to their core bond holdings. Despite the similarities with high-yield bonds, it doesn’t need to be an “either/or” investment decision, meaning investors can hold allocations of both.
But there is no free lunch—the higher yields that both investments offer come with higher risks, and investments in either should be done in moderation. Total allocations to investments that we characterize as “aggressive income” should make up no more than 20% of an overall portfolio.
Schwab clients considering bank loan funds can explore Schwab’s Mutual Fund OneSource Select List or explore bank loan ETFs through the Exchange-Traded Fund Screener. When searching for bank loan funds, first start in the “Taxable Bond” category, and then search for “Bank Loan” under the Morningstar Category.
1 Source: Morningstar Direct, as of 12/31/2020
2 S&P/LSTA Leverage Loan 100 Index total return from 2/23/2020 through 3/23/2020 was -22.5%.
3 Source: Schwab Center for Financial Research with data from Bloomberg. Net inflows represent the net inflows to the seven largest bank loan ETFs in the week ending 1/8/2021.