By Heather Rupp, Peritus Asset Management
Investing in variable rate bank loans has been a popular strategy this year, given investor concerns about higher rates. We’ve seen positive fund flows into floating rate loan mutual funds and exchange-traded funds (ETFs) in 15 of the past 16 weeks, and so far this year, $8.1 billion in inflows into mutual lending funds and exchange-traded funds.(1)
At first glance, this appears to be a “no-brainer” trade, and many have embraced it as such, but the actual numbers tell a slightly different story. For example, 2013 was the last annual period in which we saw a significant increase in US Treasury rates, and during that period $63 billion was invested in floating rate mutual funds and exchange-traded funds.(2) However, in 2013, floating rate loans yielded 5.3% versus 8.2% for high-yield bonds.(3)
So even with the 10-year Treasury yield rising over 1.2% and the 5-year Treasury yield rising over 1.0% (both to over 50% of their respective yields at the start of the the year) (4) and a massive amount of inflows into the In 2013, the high yield bond market, aided by higher initial yields, again outperformed the loan market, despite the fact that the bond market high yield bonds posted slightly negative net outflows for the year.(5)
Another consideration when investing in the loan market should be to understand what the “floating” rate is related to. Bank loans are generally based on short-term LIBOR rates, which are not necessarily closely related to the longer-term 5- and 10-year Treasury rates, which are the most relevant rates for high-yield bond investors. .
Related: The LIBOR spike and why it matters
For example, throughout 2013-2015, LIBOR remained virtually flat, while Treasury rates surged. Then in 2016 we saw LIBOR rise while Treasuries fell. Only in the last year and a half have both LIBOR and 5-year increased.(6)
The relevant interest rate is important, but equally important is understanding how the actual spread from that base rate works. Loans differ from bonds in that bonds are typically issued with a non-call period covering the first few years after issuance, then have a fixed call schedule indicating the premium prices at which the company can redeem the bonds at course of the following years.
Depending on the term of the bond, this often provides the investor with call protection for a large portion of the term of the security. However, with variable rate loans, this call protection period is usually much shorter. With a newly issued loan, you may have no appeal protection for the first six months to a year or two, but many loans are issued without appeal protection. Given the imbalance of supply and demand in favor of issuers lately, there is often no call protection for loan investors.
Related: ETF Trends Fixed Income Channel
Why is this important? Because very minimal call protections can lead to constant “repricing” activity. This means that the issuer approaches the investor to lower the interest rate of the loan. The loan remains unpaid but now the investor is faced with a lower rate. So, while investors must approve the price review, in times of high demand it is not difficult for issuers to pass the price review activity (because the alternative is that they completely call the loan and the investor loses the stake).
Over the past two years, we have seen a huge wave of price revisions. In 2017, 45% of the $974 billion in gross new issuance volume was related to revaluations and so far in 2018, 48% of the $304 billion in gross new issuance is related to revaluations.(7) Funds index/liability bank loans track a specific index and thus hold a large portion of the securities in that index. When a security is re-priced and remains outstanding and becomes part of the index, then such funds would be subject to a lower total coupon rate on that security.
In a period like the one we’re experiencing right now, interest rates can go up via the increase in LIBOR, so the loan base rate goes up, but with the revaluations that span the base rate, that may go down, which means that the actual total coupon rate the investor receives may actually be down, or at least up much less than the LIBOR movement indicates.
An additional note, the general perception seems to be that loans are always less risky than bonds. In many cases we see a bifurcated capital structure, where the company has part of its capital structure in a variable rate loan and a revolver, which is senior in the capital structure and secured, and then the remaining part of the debt issued is in subordinated bonds.