Bank loans are back: here are 2 to look out for

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Bank loans did not attract investors in 2019 and 2020 due to falling interest rates. But economic recovery and the possibility of rising short-term interest rates brought that category back in 2021. UIFs that provide bank loans received a net inflow of more than $ 13 billion in the year to April 2021, which was almost a quarter of the category’s assets at the beginning of the year. Demand for high yield bond funds has been more moderate this year, despite the similarity of the two asset classes. While high yield bonds have more upside potential, the protective characteristics of bank loans make them an attractive portfolio diversifier. The unique characteristics of floating rate bank loans, their capital hierarchy and the sectoral structure of the loan market, all create an attractive opportunity for relative value versus high yield bonds.

Although bank loans offer lower yields than junk bonds, they do have some attractive qualities. Bank loan coupon payments are made using Libor every few months, so loans carry very little interest rate risk. When yields rise, bank loans retain their value, while prices for fixed-rate bonds fall. For this reason, Morningstar’s bank lending category has outperformed the high-yield bond category in historic periods of rate hikes, such as the 2013 downturn hysteria and the interest shock in the first half of 2018.

The advantage of bank loans over high yield bonds in the capital structure of many issuing companies is another attractive feature. While the average default rates for loans and bonds have been very similar over the past two decades, the average rate of return on loans was 1.5 times higher than for bonds. As a result, high-yield bonds may suffer more than loans during credit sell-offs. During the credit sell-off from February 20, 2020 to March 23, 2020, the average fund in the bank loan category decreased by 20.4%, while the average fund in the high yield bond category decreased by 21.2%. The bank loan category was also better than 100 basis points when the credit markets sold out in the fourth quarter of 2018. Of course, these performance differences are not large, and bank loans also yielded to high-yield bonds during times of stress, such as in 2008, when leveraged buyers closed positions to meet margin calls. But their seniority in the capital structure should provide some additional protection against irrecoverable capital losses in the event of a default, which makes loans generally preferable to bonds when defaults increase.

In addition, there are fewer cyclical industries in the structure of the bank loan market than in the high yield bond market. Energy is the largest industry in the high yield bond market and accounted for 13% of the Morningstar US High-Yield Bond Index as of April 2021, compared to less than 3% for the S & P / LSTA Performing Loan Index. Instead, services, information technology, and healthcare have made up the majority of the bank lending market, leading to less volatile returns over time.

Floating T. Rowe Price (PRFRX)which is rated Gold by Morningstar Analysts, is one of the best Morningstar offers in the Bank Loans category. Lead Manager Paul Massaro has been leading the strategy since its inception in 2011, backed by a strong credit research team. The team’s high conviction and selectivity have resulted in stable risk-adjusted returns from the outset, a strategy that has worked well both during sales and in strong markets. The team chooses places carefully; it focuses on loans with ratings BB and B and is selected among CCC loans that have given the lowest total return and highest volatility compared to other credit rating levels in the last 25 years. The team’s ability to choose was demonstrated by its average default rate of 0.1% since inception, while in the bank loan market, the average default rate was 3%.

Massaro and his team have also demonstrated strong liquidity management during times of credit stress and volatile cash flows. Maintaining a liquid portfolio is especially important for bank lending strategies as loans take longer to repay and repayments are especially significant when markets sell off. The team typically maintains more than 5% of the portfolio’s assets in cash and holds high yield bonds as a liquidity buffer before disbursing a loan. One of the challenges lately has been the growth of the strategy’s assets in 2021, as bank loans have become popular. Cash flow poses a challenge to using cash while maintaining high standards, but T. Rowe Price has built a reputation for responsible capacity management by closing funds before asset growth could potentially interfere with the strategy’s investment process.

Silver rated High income floating rate Fidelity (FFRHX) also a solid option. Fundamental credit research is a hallmark of Fidelity’s bank loan business. The strategy is guided by experienced managers Eric Mollenhauer and Kevin Nielsen with deep support. His 22-person analyst team as of September 2020 includes two bank-specific analysts who study only issuers of loans, while the rest of the cohort covers the entire capital structure by industry. In addition to the usual credit analysis, management estimates and profit forecasts, the team pays close attention to the structure and covenants of each transaction. The strategy is geared towards larger companies – in part a necessity due to its size – but this makes it a more predictable and cautious choice among competitors.

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