By Dan Hallett on January 16, 2020
Razor-thin interest rates have motivated investors to reach for extra returns for years. Accordingly, many investors have invested in investment funds holding bank loans – a.k.a. senior secured loans, leveraged loans, term loans, floating rate loans, institutional bank loans. I wrote about floating rate loan funds five years ago; highlighting liquidity risk – which remains. The loan market has evolved over the past five years in good and bad ways. Risks, however, are higher than ever; and inaccurate labeling of funds and holdings masks true investment exposures.
Bank loans involve companies that are weaker credits borrowing money from a bank. The bank may ask other banks to participate in funding the loan. The bank(s) then sell off parts of the loan to institutional investors – e.g., floating rate loan investment funds – leaving them with fee revenue for underwriting the loan but with very little credit exposure.
The appeal of bank loans as investments is two-fold: i) they offer mid-to-high single-digit yields (because borrowers are higher risk); and ii) they typically bear a floating interest rate so they’re immune to often-feared higher rates. But bank loans differ from high yield bonds in important ways.
Bonds, stocks, and treasury bills are “securities”. Securities trades are cleared and settled in a centralized manner. Buys and sells are electronically matched (which happens in seconds); and trades are settled via the exchange of cash for securities (which takes two business days – denoted as T+2). Bank loan trades, on the other hand, are very manual.
Loan Trading Mechanics
Loans are not “securities”. Trades typically take a few weeks to complete according to Canso Investment Counsel of Richmond Hill, Ontario. Loan trade execution and settlement, they say, require physical documents to be processed and often involve fax instructions. Canso notes that ClearPar (a loan trading platform owned by Markit) facilitates the processing of the key documents required to trade loans – e.g., the assignment & assumption or participation agreement; the funding memo; and the trade confirmation.
The length of time it takes to complete a loan trade is never known in advance. Trades require at least a calendar week to settle (i.e. five business days or T+5). At the other extreme, loan trades may need two months (i.e. T+40) to settle. While some managers claim to be able to trade with quicker settlements, the average seems to be a few weeks (T+15). The length of time is only known once a trade settles.
This lengthy settlement process creates a liquidity mismatch when held inside of an investment vehicle that can be bought or sold on T+2 terms (e.g., a mutual fund, pooled fund, or exchange-traded fund). Here’s a simple example to illustrate.
Suppose you and I each hold 50% of a $100k loan fund. If I sell my half, the fund must give me $50k in two business days. Since the fund must sell $50k of loans to pay me out; the fund must wait three weeks before it receives that cash. How does a fund make sure it can cover that three-week cash flow gap?
It can set up and use a line of credit. If a fund is attracting new cash from investors, it can use that cash inflow to pay departing investors. Finally, loan funds often keep a “liquidity bucket” – i.e. more liquid holdings – that can be sold when it needs cash quickly. These strategies work well; but will become much more challenging during a credit crisis.
Weaker investor protections
Companies borrow money contingent on promising to maintain certain profitability, cash flow, and financial leverage standards – i.e. loan covenants. Bank loans are no different. Loan covenants have been dropping for years such that 85% of bank loans are now “covenant-lite”; compared to less than 10% a decade ago (source: S&P Global Market Intelligence via Business Insider). That means that borrowers will be allowed to get in much worse financial shape before they will be considered in default; leaving less potential for full loan recovery by investors.
This August 2018 announcement by Moody’s Investors Service notes that increasingly-lower quality businesses are borrowing money via the loan market. Borrowers have also adopted increasingly-aggressive financial policies (facilitated by the proliferation of covenant-lite loans) according to Moody’s. Finally, there are more second lien loans than in the past. Accordingly, Moody’s and Canso said that a rise in loan defaults is inevitable; and when that happens, investors will see much lower recovery rates – i.e. steeper losses – than in the past.
Moreover, a paper published in December by the Financial Stability Board (FSB) notes that a big source of additional money invested in loans is from collateralized loan obligations – or CLOs. Those letters may ring a bell because pre-2008 CLOs bought sub-prime mortgages and sold investors cash flow streams called “tranches”. They ultimately went bad during the financial crisis.
CLOs have accounted for more than 100% of new loan issuance in each of the last five years (source: JP Morgan); and now own most the leveraged loan market. While CLOs are selling “tranches” of loans to institutional investors; the FSB notes that CLO structures have improved since the financial crisis. They concede, however, that under severe scenarios CLOs could compound pressure on loan prices and liquidity.
(Mis)truth in labeling
Any potential to earn attractive returns involves risk. But I am convinced that many investors in bank loan products don’t understand what they own. Part of the blame rests on investors (or their advisors); but the onus should be on product sponsors to properly label products. There are twenty “floating rate” income funds in Canada. Of the 17 funds that are focused on bank loans, just 6 contain the word “loan” in the name.
Most funds also mis-label their holdings. I scored each fund on how accurately holdings are labeled on website profiles and regulatory Fund/ETF Facts. The scoring is explained in a note to the accompanying table, but the average score was 4 out of 10. In too many instances, I had to dig to determine each fund’s allocation to loans relative to bonds and other holdings. The accompanying table also contains accurate loan exposure based on the most recent data available.
[Click for PDF data table: Floating Rate Funds Table]
Senior Secured Bank Loans can be attractive investments because of they often stand first or second in line to claim assets in the event of default. And they offer attractive yields in this low-rate environment; but that’s because they involve higher credit risk. We initially avoided bank loans because of the liquidity mismatch. However, the asset class has become much riskier in my view.
For its part, Canso lists bank loans as one of its biggest worries. The investment industry often takes a good idea too far; which may be the case with loans today. Canso devoted a good portion of their December 2019 Corporate Bond Newsletter to this issue; so it’s a worthy read.
I don’t expect to curb investors’ reach-for-yield tendencies. But if investors better understand what they own, they will be in a better position to ask good questions and make more informed decisions.
Post-Script: Impact HighView portfolios
While we have material exposure to floating rate bonds; those are all high quality and very liquid. We have zero exposure to bank loans. Where we have taken steps to boost returns and yield in client portfolios; we have done so armed with a full picture of risk and return.