Read the latest paper from Paul Jackson, our Global Head of Asset Allocation Research. He shares in-depth analysis on bank loans, before delving into the role the asset class can play in investor portfolios.
It has been a while since I used the Beyond the Madding Crowd label, inspired by Victorian English writer Thomas Hardy. It denotes a deep dive into a particular topic, rather than getting lost in day-to-day market noise. The subject matter this time is bank loans – an asset class that I am often asked about, but which has not featured in mine and András Vig’s asset allocation framework to date.
In this piece, I aim to answer some of those “frequently asked questions”, as well as looking at the role bank loans could play in our asset allocation framework* and your portfolios going forwards.
*This is a theoretical portfolio and is for illustrative purposes only. It represents our views and does not represent an actual portfolio. Nor is it a recommendation of any investment or trading strategy.
For those who are short on time, I summarise my main conclusions here.
Read the full paper for further insights.
Bank loans are loans issued by banks to institutions (banks and other entities) that are the most senior, secured debt. They sit at the top of the borrower’s capital structure. In other words, if the debtor company has problems, bank loans have higher priority than bonds, which has historically resulted in higher default recovery rates.
When banks want to reduce their exposure to loans, they can be sold. Loans are often combined, repackaged and sold to investors who receive interest payments and principal repayment in return.
Most leveraged loan indices only include loans that are rated below investment grade. They are called leveraged loans due to their frequent use in the financing of leveraged buyouts.
These terms are typically used interchangeably to refer to the asset class. The “senior” or “senior-secured” label refers to the fact that the asset class sits at the top of the borrower’s capital structure.
Bank loans are secured on the assets of the borrower, but are usually non-investment grade. This makes for a natural comparison with the high yield credit segment of the fixed income universe. This explains why they offer a high rate of interest.
The big difference between high yield bonds and bank loans is that the latter usually offer a floating rate linked to a benchmark such as LIBOR (London Interbank Offered Rate) or SOFR (Secured Overnight Financing Rate).
Bank loans have an advantage over bonds when interest rates rise, as they are typically “floating rate” assets. In other words, the income flows adjust upward rather than remaining fixed. For this reason, it is often said that bank loans have near-zero duration, despite having multi-year maturities.
As introduced previously, bank loans sit at the top of the borrower’s capital structure. If the debtor company has problems, bank loans have higher priority than bonds, which has historically resulted in higher default recovery rates.
In both the US and Europe, the bank loans market appears to be roughly the same size as the respective high yield market:
Given its characteristics, the bank loan asset class occupies a place in the risk-reward space somewhere between cash and high yield. Its income flows come from variable interest rates (like cash), but the loans are usually non-investment grade.
Our analysis, outlined in detail in the above paper, suggests that the best environments for bank loans are the recovery after recession (when spreads are likely to be wide) and a prolonged economic upswing that brings rising central bank rates but low defaults.
Each quarter, András Vig and I publish an in-depth view of our model asset allocation, outlining which asset classes we favour and why. This is called The Big Picture.
Model portfolios consist of a diversified group of assets. They are designed to achieve an expected return with the corresponding risk. Model portfolios are usually extensively researched and, in most cases, have a combination of managed investments.
Given its size and characteristics, we intend to incorporate the bank loan asset class into our model asset allocation framework by the end of 2023.
Our private credit teams manage bank loan, direct lending and distressed credit strategies. Learn more about the offering and read our latest insights.
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Alternative investment products may involve a higher degree of risk, may engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, may not be required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual portfolios, often charge higher fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager.
Data is provided as at 30 June 2023, sourced from Invesco unless otherwise stated.
This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. Views and opinions are based on current market conditions and are subject to change.
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