Thornburg Investment Management
July 05, 2017
Thornburg is a global investment firm delivering on strategy for institutions, financial professionals and investors worldwide.

Bank Loans Beat High Yield Amid Rising Rates? Don’t Bank on It

By Christian Hoffmann, CFA

 

Bank loan products are often seen as a nice alternative to high yield in a rising interest rate environment, but the conventional wisdom about their interest rate protection and security needs a credit check.

Bank loan  funds have been widely touted as a great way to help fixed income investors ride out a rising interest rate cycle. Also known as levered loan or senior loan funds, they are, after all, high yielding but with a variable rate. So, in theory, they not only provide elevated income but can also avoid the interest rate risk to which fixed rate bonds are subject (bond prices and yields move in inverse directions). What’s not to like? Especially now that the Federal Reserve is in tightening mode and increasing short term rates. The only problem is that the theory isn’t borne out in practice.

As the following charts show, since the Fed first initiated its tightening cycle in December 2015, high yield has vastly outperformed the return of bank loans.

LEVERED LOAN RETURNS COMING UP SHORT VS HIGH YIELD AMID CURRENT FED TIGHTENING 12/14/2015 - 6/27/2017

Source: Bloomberg

A handful of factors can explain the divergence in performance. Rising short-term rates typically coincide with an improving macroeconomic environment, which can actually be favorable for non-investment grade credit products. The rising economic tide tends to keep default rates low via favorable business conditions. It is worth noting that in an environment like that, levered loans have almost no upside potential, given that they usually have limited-to-no call protection—so as spreads tighten, companies refinance at lower spreads. To put it in terms of upside/downside, leveraged loans generally have 0-to-1 points of potential upside and 100 points of potential downside. But it should be noted that on average defaulted levered loans have tended to recover ~80 cents, which is superior relative to the average recovery on high yield unsecured bonds—though any one outcome could be materially better or worse than that.

Other issues also weigh on bank loan products. Although both high yield and levered loans are of lower credit quality, and bank loans generally come with first-lien security provisions, many bank loans are sourced from very small companies that could not support a bond offering—so the security is an enhancement, but in no way does it mean you cannot lose money. Moreover, liquidity is far more challenged for bank loans than bonds, with far fewer dealers trading them, longer timeframes to settle trades and opaque pricing transparency, which can negatively impact total return.

It is comforting but incorrect to believe that levered loans will always outperform in a rising rate environment and also incorrect to believe that levered loans will always outperform in a weak macro or weak market environment. The graphs above demonstrate underperformance during the most recent rising rate environment. The graph below also demonstrates underperformance during late 2008, which is probably the best example of market and macro weakness we’ve experienced in the past twenty years or so.

LEVERED LOANS DOWNSIDE VS HIGH YIELD 1/08/2008 - 3/31/2009

Source: Bloomberg

None of this is to say that levered loans are evil or terrible outright. The floating rate structure and security package are real structural enhancements, but need to be weighed against other less attractive structural and market considerations, as it is clear there are gives and takes. Investors in bank loan funds should be well aware that they aren’t the silver bullets that many believe.

LEVERED LOANS UPSIDE VS HIGH YIELD 1/31/2008 - 1/31/2017

Source: Bloomberg

  

Read more Global Perspectives from Thornburg >>

  Important Information
Before investing, carefully consider the Fund’s investment goals, risks, charges, and expenses. For a prospectus or summary prospectus containing this and other information, contact your financial advisor or visit our literature center . Read them carefully before investing.

The performance data quoted represents past performance; it does not guarantee future results.

The views expressed are subject to change and do not necessarily reflect the views of Thornburg Investment Management, Inc. This information should not be relied upon as a recommendation or investment advice and is not intended to predict the performance of any investment or market.

Investments carry risks, including possible loss of principal.

Bonds are subject to certain risks, including interest-rate risk, credit risk, and inflation risk. The principal value of bonds will fluctuate relative to changes in interest rates, decreasing when interest rates rise.

Please see our glossary for a definition of terms.

Thornburg mutual funds are distributed by Thornburg Securities Corporation.

Thornburg Investment Management, Inc. mutual funds are sold through investment professionals including investment advisors, brokerage firms, bank trust departments, trust companies and certain other financial intermediaries. Thornburg Securities Corporation (TSC) does not act as broker of record for investors.

Disclaimers & Disclosureskeyboard_arrow_up

To learn more, please visit www.thornburg.com

The views expressed by the portfolio managers reflect their professional opinions and are subject to change. Under no circumstances does the information contained within represent a recommendation to buy or sell any security. Investments carry risks, including possible loss of principal. Investments carry risks, including possible loss of principal. Portfolios investing in bonds have the same interest rate, inflation, and credit risks that are associated with the underlying bonds. The value of bonds will fluctuate relative to changes in interest rates, decreasing when interest rates rise. Unlike bonds, bond funds have ongoing fees and expenses. Investments in the Funds are not FDIC insured, nor are they bank deposits or guaranteed by a bank or any other entity. Please see our glossary for a definition of terms: http://www.thornburg.com/legal/glossary.aspx Thornburg mutual funds are distributed by Thornburg Securities Corporation. Thornburg Investment Management, Inc. mutual funds are sold through investment professionals including investment advisors, brokerage firms, bank trust departments, trust companies and certain other financial intermediaries. Thornburg Securities Corporation (TSC) does not act as broker of record for investors.

Before investing, carefully consider the Fund’s investment goals, risks, charges, and expenses. For a prospectus or summary prospectus containing this and other information, contact your financial advisor or visit our literature center. Read them carefully before investing: https://www.thornburg.com/forms-literature/product-literature/mutual-funds/index.aspx



More from Thornburg Investment Management