September 22, 2017— We are occasionally asked if we view the bank loan (also leveraged loan) space as attractive. While we are not addressing complete market credit conditions here, we can comment on some unique aspects of the bank loan market that impact our view.
This asset class is composed of loans traditionally made to high-yield, or non-investment-grade borrowers. Bank loans are frequently higher in the capital structure than traditional fixed-rate high-yield bonds and are usually secured. Bank loans are also floating rate instruments that pay interest above a benchmark yield/rate, such as 3-month Treasuries or LIBOR. However, unlike the fixed-rate high-yield bond market, bank loans can typically be pre-paid at virtually any time with the payment of a small premium, usually starting within a few months of issuance.
In situations where the issuer has an improved credit profile and/or the market perceived risk of the issuer is lower, this should result in appreciation of the loan above par, indicating a lower cost of borrowing. If this occurs, issuers will frequently pre-pay a current issue and refinance with a new bank loan issuance at a lower interest rate spread above the benchmark rate (very similar to homeowners refinancing a mortgage). Fixed-rate high-yield bonds typically cannot be pre-paid for five years from issuance or may require payment of a meaningful premium to refinance. Within the bank loan market, this prepayment capability should effectively cap the upside price of individual securities near par. This is very different from a fixed-rate high-yield bond that may not be pre-paid for a number of years, as its price could move meaningfully above par.
One metric we review on a consistent basis is the portion of the bank loan market that trades above par. We follow this metric as we believe it is a good indicator of investor demand for yield and can lead to situations where investors have immediate risk of principal if they purchase loans above par that can be immediately refinanced with new issues. Figure 1 shows the 3-month moving average percent of the Credit Suisse Leverage Loan index trading above par. As one can see, in robust credit markets (e.g., 2005–2007, 2013, and today), a large portion of the market will trade above par, indicating a combination of healthy underlying corporate fundamentals and a reach for yield. Further, it should come as no surprise that during the 2008 credit crisis, virtually none of the index was above par. Recent data indicate that this is the third-most pronounced period of investor demand, as roughly 55% of the index is trading above par.
Percent of Credit Suisse Leveraged Loan Index trading above par
(3-month moving average)
Source: Credit Suisse and Deutsche Bank
The second technical aspect of the bank loan market is the covenants that are embedded within the loan documents. These covenants provide protections for investors by requiring a borrower to maintain certain financial ratios. While newly issued bank loans do maintain other covenants, we highlight the fact that a key type of covenant is missing. Loans without these protections are called “covenant lite.” As can be seen in Figure 2, the portion of the index that does not contain these protections has grown substantially over the past few years.
Percent of Credit Suisse Leveraged Loan Index that is “covenant lite”
Source: Credit Suisse and Deutsche Bank
Given the combination of premium pricing and reduced investor protections, we have a zero weight to the asset class in our tactical asset allocation. We would reconsider the asset class when conditions are much more favorable to the investor.
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