03.31.2014
By Terry Flanagan

Bank Loans Attract Investors

Floating-rate debt in the form of bank loans is being used as a hedge against a rise in short-term interest rates, which the Federal Reserve has said may begin as early as next year.

An estimated $61 billion in net inflows flooded into open-end mutual funds, while bank-loan exchange-traded funds took in $6 billion, and the category has grown tenfold since late 2008.

“Bank loans are probably among the more prominent floating rate credit asset classes, and it’s also probably one of the only asset classes that’s almost entirely floating rate,” said Steven Oh, global head of credit and fixed income at Pinebridge Investments. “You could argue that CLO debt tranches are also equal or in some ways better risk, but it’s a very illiquid asset class and not quite as mainstream.”

It’s not hard to understand why the asset class has drawn so much interest, according to Morningstar analyst Sarah Bush. For starters, bank loans offer relatively attractive yields; recently the average fund in the category had a 3.5% SEC yield. More important, floating-rate leveraged bank loans feature a floating interest rate that is set at a spread over Libor and periodically resets to capture changes in that rate.

“There’s a lot of concern in the fixed income market that the Fed will eventually raise short term interest rates and that interest rates will go up,” said Oh, who oversee all of Pinebridge’s fixed income strategies totaling about $30 billion of assets across emerging and developed markets. “If you’re investing in traditional fixed rate bonds, you have a risk of a potential loss if rates go up. With floating rate instruments, you don’t have that risk because the coupon will adjust as the rates go up.”

The terminology “fixed income” denotes that the coupon is fixed in nature. However, floating rate assets or floating rate bonds are those debt instruments where the coupon changes and are tied to a short-term index. The most common index tends to be three-month Libor. “The way to think about it is like an adjustable rate mortgage,” Oh said. “It’s an adjustable rate debt instrument where the rates adjust every three months, so the coupon changes.”

All of Pinebridge’s current fixed income portfolios are long only portfolios, comprising three buckets. One is leveraged finance, which is non-investment grade bank loan and high yield bond. The second is developed market investment grade. The third component is emerging markets.

“We also manage multi-asset strategies that cross those asset class boundaries,” said Oh. “The way to think about us is we’re a long only multi-asset class global fixed income investor.”

The high yield bond market is the closest relative to bank loans. “The bank loan market is a bit less liquid than the high yield bond market and probably it’s similar to what the high yield bond market liquidity may have been about ten years ago,” said Oh.

Historically, the term “bank loan” still holds because it’s basically debt that commercial banks make to corporations. Either a bank or a group of banks will underwrite a debt to a corporate issuer or a corporate borrower, then that debt is broadly syndicated to investors like Pinebridge and other investors. While not technically a security, it trades and behaves in a very similar fashion to any other bond or other security.

“It isn’t treated as an asset backed security because one of the distinguishing factors of asset backed securities is they’re typically pools of assets and they are tranched out like credit cards and auto receivables,” said Oh. “Whereas bank loans are direct borrowings from a corporate borrower.”

Featured image via Flickr/KmpFoto under CC

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