The Case for Bank Loans in a Rising Rate Environment

At RidgeWorth, we believe investors should have exposure to Bank Loans in their portfolio, especially in rising rate environments. Our White Paper explains that Bank Loans have offered:

  • A hedge against rate increases – Unlike traditional fixed rate bonds, the coupons of Bank Loans reset with increases in interest rates. Consequently, the sensitivity of a Bank Loan portfolio’s market value to changes in interest rates is small.

  • Low correlation to other asset classes – Bank Loans held their value and generated added income in rising interest rate environments when the prices of fixed rate bonds declined.

  • Downside protection – Bank Loan’s senior position in the capital structure may help manage downside risk if the economy takes a turn for the worse. Recovery rates for Bank Loans during the most recent downturn in 2008 was 62% vs. 34% for High Yield Bonds.

  • Lower risk High Yield exposure – The risks typically associated with traditional High Yield products are mitigated since Bank Loans are high in the capital structure and usually have had higher recovery rates.

What are Bank Loans?
Bank Loans, commonly referred to as “floating rate loans,” are privately structured debt obligations issued by corporations, often rated below Investment Grade, that seek to raise capital. The most important feature of Bank Loans is their seniority in the capital structure (see Exhibit 1). Loans are primarily composed of first lien and senior-secured debt that takes precedence over other debt claims in the case of default or bankruptcy. Bank Loan coupons in general reset in line with the 1-, 3- or 6-month London Interbank Offered Rate (LIBOR). This floating rate feature lowers the interest rate risk of Bank Loans compared to other fixed income products. Also, many Bank Loan documents contain highly restrictive covenants that prevent companies from issuing additional debt if financial ratios would be pushed over certain predetermined levels.

Exhibit 1: Priority of Bank Loans Across the Capital Spectrum

Spectrum Image for Bank Loan

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Additional Resources

Past performance does not guarantee future results. This information is educational in nature, provided as general guidance on the subject covered, and is not intended to be authoritative or to provide tax or investment advice.

Investment Considerations & Definitions
Mutual fund investing involves risk, including possible loss of principal. Bonds offer a relatively stable level of income, although bond prices will fluctuate providing the potential for principal gain or loss. Intermediate-term, higher-quality bonds generally offer less risk than longer-term bonds and a lower rate of return. Floating rate loans are typically senior and secured, in contrast to other below-investment grade securities. However, there is no guarantee that the value of the collateral will not decline, causing a loan to be substantially unsecured. Loans generally are subject to restrictions on resale. Certain types of loans may limit the ability of a Fund to enforce its rights and may involve assuming additional credit risks. Although a fund’s yield may be higher than that of fixed income funds that purchase higher-rated securities, the potentially higher yield is a function of the greater risk that the Fund’s share price will decline.

Investments in lower rated bonds are subject to greater credit risk and may experience greater volatility than higher rated securities.

Recovery Rate is the amount that a creditor would receive in final satisfaction of the claims on a defaulted credit.

A bank loan fund may buy and sell securities frequently, which may result in higher transaction costs and lower performance, and will be more likely to generate short-term capital gains (which are generally taxed at ordinary income tax rates).

Rating agencies such as Standard & Poor’s, rates securities from AAA (highest quality) to C (lowest quality) with BBB and above being called investment grade securities. BB and below are considered below investment grade (speculative) securities.

Credit Suisse Institutional Leveraged Loan Index is a subindex of the Credit Suisse Leveraged Loan Index which contains only institutional loan facilities priced above 90, excluding TL and TLa facilities and loans rated CC, C or in default. It is designed to more closely reflect the investment criteria of institutional investors. Bank Loans are represented by the Credit Suisse Leveraged Loan Index. Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the $US-denominated leveraged loan market. Loan facilities must be rated “5B” or lower. That is, the highest Moody’s/S&P ratings are Baa1/BB+ or Ba1/BBB+. If unrated, the initial spread level must be Libor plus 125 basis points or higher. Only fully funded term loan facilities are included. The tenor must be at least one year. Issuers must be domiciled in developed countries; issuers from developing countries are excluded. 3- Month Libor is a filtered average of rates charged by banks for unsecured, 90-day loans to other banks.