Overview
Bank loans, also known as senior or leveraged loans, have gained popularity as investment vehicles. They offer high yields and protection against rising interest rates. However, like any investment, they come with risks. This review examines the benefits and drawbacks of incorporating bank loans into investment portfolios.
What Are Bank Loans?
Bank loans are privately traded, senior secured loans typically issued to companies rated below investment grade. These loans are “senior” because they have priority over other debts, such as unsecured bonds and subordinated debt. They usually have terms of 5-8 years and feature floating interest rates tied to the Secured Overnight Financing Rate (SOFR) plus a spread reflecting the borrower’s credit risk. For example, a loan might be priced at SOFR + 450 basis points. If SOFR is 5.15%, the total rate would be 9.65%.
Interest Rate Mechanics
The interest rates on bank loans are adjusted quarterly, providing some protection against rising rates. However, newer loans may include a “SOFR floor,” setting a minimum interest rate regardless of SOFR levels. This feature can expose loans to interest rate risk until SOFR exceeds the floor rate. Additionally, while SOFR is a short-term rate, it can move independently of longer-term rates, potentially affecting the loan’s value.
Credit Risk
Bank loans carry significant credit risk, similar to high yield bonds, as they are typically issued by companies with below-investment-grade credit ratings. However, their senior status in the capital structure generally ensures a higher recovery rate in the event of default. Most bank loans are callable at par, allowing issuers to refinance at lower rates if their credit improves, which presents an asymmetric risk to investors.
Liquidity Risk
Market liquidity is a key risk for bank loans. Although the market’s total value is about $1.3 trillion, it constitutes only a small fraction of the U.S. debt market. In normal conditions, loans are liquid, but during market volatility, mass selling could lead to significant losses. Investors should consider this when deciding how to hold bank loans.
Investment Vehicles
There are several ways to invest in bank loans. Direct investment is challenging due to the private nature of the market. However, private funds, mutual funds, and exchange-traded funds (ETFs) offer access to individual investors. Private funds, though offering some protection against forced selling, have higher fees and restricted liquidity. Mutual funds and ETFs provide liquidity and low minimums but are susceptible to market liquidity risks.
Empirical’s Approach
Empirical primarily uses mutual funds to gain exposure to bank loans. These funds combine high yields, potential rate increases, and seniority in the capital structure, making them an attractive option for enhancing income in a bond allocation. Diversified funds mitigate the risk of individual loan defaults. Investors should assess the risks and consult advisors before investing.
Contact Empirical Wealth Management and we can help you navigate your investment options and make informed decisions for a secure financial future.
Conclusion
Bank loans offer appealing features such as high yields and floating rates but come with significant risks, including credit and liquidity risks. Proper assessment and understanding are crucial before including them in portfolios.
- 1. The Secured Overnight Financing Rate (SOFR) is a broad measure of the cost of borrowing cash overnight collateralized by Treasury Securities.
- 2. Source: Pitchbook ( Pitchbook Primer: Understand Leveraged Loans | Pitchbook)
- 3. Source: SIFMA (http://www.sifma.org/research/statistics.aspx)
- 4. This refers to a 2% management fee and 20% carried interest (meaning the manager receives 20% of profits over a given minimum performance level).
