There is a sub-sector within the bond market that is getting quite a bit of attention lately: floating rate bond funds. These funds may also be known as senior secured loans, bank loans or leveraged loans. Going forward, I’ll refer to them as bank loans just to keep things simple, but given their unique characteristics, it’s worth looking at them in more detail. Here are three reasons why bank loans may be a good fit in your portfolio relative to investment grade and high yield bonds:
1. Low interest rate risk. With traditional bonds, investors receive a fixed coupon payment on a set schedule (hence the term “fixed income”) and the value of the bond fluctuates as interest rates move. When interest rates go up, the price of bonds fall, and when interest rates fall, bond prices increase. This is at the heart of what interest rate risk is: it’s the risk that bond values adversely change due to fluctuating interest rates.
That relationship between interest rates and price doesn't exist with bank loans, which is what makes them attractive to investors now. The coupon on bank loans is variable as it resets to the current interest rate every three months keeping its price at or near par. Sure, the price can trade at a premium or a discount before the coupon resets, but overall, bank loan prices are fairly stable despite changes in market rates.
2. High recovery rates. Typically, bank loans are issued by non-investment grade companies, so you can think of them as the floating rate version of high yield. As is the case with any entity that issues a bond, an investor must evaluate the creditworthiness of the borrower and determine two key items: the likelihood of default and the recovery rate in the event of default. It should go without saying that, all else being equal, you want to find a borrower (or an investment) with a low chance of defaulting or make sure you get as much of your investment back as possible if they do.
On one side of the bond spectrum you have investment grade with very low probabilities of default. In the corporate world, these issuers are large companies with steady cash flow and little chance of not being able to make their interest payments each month. On the other side you have high yield with much higher rates of default. While bank loans are closer to high yield bonds in terms of credit risk, they have a unique feature which results in much higher recovery rates. Holders of bank loans are the first group of people to get paid if the borrower goes bankrupt because the loan is backed by company assets. Bank loans get an extra layer of protection not offered by high yield debt because of their seniority in line to get some of their money back.
3. Less volatile returns. A common way to assess risk is to look at how volatile the returns have been over time using a statistical measure called standard deviation. What you need to keep in mind is that the larger the standard deviation of returns, the higher the volatility of the investment and the greater the chance that you could suffer a big loss. Prior to the 2008 financial crisis, the standard deviation of bank loans was 2.3 percent. To put this number into perspective, U.S. stocks have a standard deviation of around 20 percent, high yield has a standard deviation of 8.6 percent and investment grade has a standard deviation of 5.5 percent. In other words, bank loans were an extremely stable asset class. That isn't to say that you couldn't lose money, but you weren't going to suffer any crippling losses.
Even if you include returns post-2008, that number only increases to 5.4 percent, which is still slightly below investment grade and well below high yield. Who would have guessed that there was a segment of the fixed income universe that had lower volatility than investment grade?
The bottom line: Because of their floating-rate nature, their priority over other investors in recovering potential losses and their relatively stable return profile, bank loans may provide a diversification benefit to a bond portfolio by lowering interest rate risk and volatility.
Spencer D. Rand is an Asset Management Associate at Monument Wealth Management, a Registered Investment Advisor located just outside Washington, DC in Alexandria, Va. Spencer is not a registered investment advisor representative. Follow Spencer and the rest of Monument Wealth Management on their blog which can be found on their website, on Twitter @MonumentWealth, and on the Monument Wealth Management Facebook page.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance referenced is historical and is not guarantee of future results. All indices are unmanaged and may not be invested into directly.