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Looking for Higher Yield? Consider Bank Loans
With the Fed on its way to "rate normalization," fixed income investors may want to explore new ways to gain yield through a lesser known sector, bank loans.
Bank loans are loans given to below investment-grade companies for short-term funding purposes, which are then securitized. They generate higher yield than other short-term debt because investors are rewarded for taking on added credit risk.
Despite the risks, bank loans may be positioned well for today's environment due to their capital structure seniority and lower interest rate sensitivity.
Capital Structure
Because bank loans represent debt of riskier companies, default potential and subsequent recoveries should be understood. Default forecasts for below investment grade fixed income are quite good for 2017, with rating agencies forecasting a less than 3.5% chance of default. Despite this optimistic outlook, defaults generally become more important to credit-focused investors later in the business cycle, when defaults start to materialize. The recovery rate, (as important as the default rate), is the overall percentage of capital that is recovered and returned to investors in the event of a default. Bank loans are senior debt to general obligation high yield bonds of the same company and are secured debt, meaning that these loans have a first lien claim on specific assets belonging to the corporation. This helps provide added protection in the event of bankruptcy. They also generally include contractual covenants like control of cash flows, maintenance of certain financial ratios, etc., which can help to protect investors further. Historical recovery rates for bank loans are about 80%.
Interest Rate Sensitivity
Bank loans tend to outperform higher-quality sectors in rising rate environments
due to the floating rate coupons on the loans. Bank loans are sometimes referred to as "floating rate securities" because their coupon payments are tied to a reference rate like the 3-month Libor (London Interbank Offered Rate). Libor generally moves with other short-term rates, thus when short-term rates rise, coupons rise, creating a tailwind for the bank loan sector relative to high-quality fixed income.
Although there are some clear advantages to bank loans, significant credit risk still exists within the asset class. Bank loans have the potential to be a good yield enhancer for portfolios or a good alpha generation tool relative to the high-quality Bloomberg Barclays Aggregate benchmark. However, large positions in lower-quality fixed income can be a double-edged sword: alpha generation in good times, but increased potential for downside risk in bad times. Investors should understand their own tolerance for risk, and just as importantly, think critically about the goals of their fixed income allocation.
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For the first time in 109 trading days, the S&P 500 closed down by 1% or more on Tuesday, March 21. Equity investors faced the reality that the healthcare reform bill was unlikely to pass, and they showed a concern that President Trump may not be able to implement other proposed policies like infrastructure spending and tax reforms. Mixed economic data and renewed worry over North Korea's nuclear program added to the uncertainty.
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> Brexit Update: Nine months after the people of Great Britain shocked the world by voting to exit the European Union, British Prime Minister,
Theresa May,
has informed the European council that she will trigger article 50 today, March 29, 2017. Though the 27 member states have suggested it may take 4-6 weeks before they can agree on a response, thus delaying the start of formal negotiations, the two-year Brexit clock will start ticking today and Britain's EU exit will be complete by the end of March 2019.
> Economic Growth in the US: Similar to the improvement we've seen in the Leading Economic Index (LEI), domestic economic data has broadly surprised to the upside in recent months, as illustrated by the Citigroup Economic Surprise Index below. This index measures the mix of economic data coming in above versus below economists' forecasts.
> Consumer Confidence:
The Conference Board Consumer Confidence Index®, which had increased in February, improved sharply in March. The Index now stands at 125.6, its highest level since December 2000 when the index was at 128.6.
Lynn Franco, Director of Economic Indicators at The Conference Board, explained, "Consumers' assessment of current business and labor market conditions improved considerably. Consumers also expressed much greater optimism regarding the short-term outlook for business, jobs and personal income prospects. Thus, consumers feel current economic conditions have improved over the recent period, and their renewed optimism suggests the possibility of some upside to the prospects for economic growth in the coming months."
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New Market Wealth Management offers modern investment solutions backed by extensive research and experience serving the needs of wealthy families. Through our strategic partnership with
Cliffwater LLC
, we provide institutional-quality research, investment due diligence and asset allocation tools. We believe this level of experience and unique access to in-depth, sophisticated research are essential for success in today's complex world markets.
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