Investors Flock to Bank-Loan Funds
Rising rates have sparked renewed investor interest.
Bank-loan funds made a stark return recently, as investors seeking non-investment-grade credit exposure favored the sector over high-yield bond funds. From January 2021 through March 2022, investors poured roughly $65 billion in assets into the bank-loan Morningstar Category. This brought total category assets to roughly $135 billion, which was not far off the $154 billion peak reached in March 2014. Over the same stretch, investors pulled roughly $30 billion from the high-yield bond category.
The specter of rising interest rates is a key contributor to renewed investor interest in bank-loan offerings, as bank loans' floating-rate feature protects their value in rising rate environments. The amount of income that bank loans pay to investors rises and falls as interest rates rise and fall. This aspect distinguishes loans from bonds with fixed interest rates that don’t adjust to market interest-rate changes, a dynamic that contributes to high-yield bond prices falling when rates rise.
Bank-loan strategies have generally served investors well during past rising rate environments compared with high-yield bond funds, which possess similar levels of below-investment-grade credit exposure. As short-term interest rates spiked from July 2021 through March 2022, the median fund in the bank-loan category boasted a 0.8% gain versus the high-yield category’s median fund’s 2.9% loss. Similarly, as interest rates rose from January 2018 through October 2018, the typical bank-loan fund outpaced the typical high-yield strategy by nearly 3 percentage points. However, the latter cohort’s higher energy sector exposure helped its median offering beat the former’s during the interest-rate spike that stretched from August 2016 through December 2016, as the energy sector bounced back following the commodities selloff that spanned from June 2015 through February 2016.
All is not always well in bank-loan land, however. Despite protection from rising interest rates, bank-loan fund managers are faced with challenges that include heightened liquidity management difficulties relative to other fixed-income sectors and declining investor protections in the event of an issuer default.
Bank-loan trade settlement typically takes a week or longer compared with fixed-income sectors, whose constituents generally provide two-day settlement. This poses a challenge for fund managers that hold bank loans inside of funds that offer daily redemption to investors. When fund investors redeem, managers of the funds sometimes must tap lines of credit because they can’t sell the loans fast enough, which can add small amounts of portfolio leverage.
In addition, investors have historically yanked assets out of the bank-loan category at a faster clip than similar corporate-focused fixed-income categories. Over the trailing 10 years ended March 2022, Morningstar Direct data show that during quarters when investors withdrew assets from the bank-loan category, they typically did so at more than double the rate than during quarters when they pulled money from corporate bond and high-yield bond categories. This phenomenon exacerbates liquidity management challenges that bank-loan fund managers navigate, as they can face sizable quarterly outflows when investor sentiment shifts.
Bank loans’ priority position in an issuer’s capital structure is another defining feature, though the protection it provides has declined in recent years. Loans are first in line to be repaid in the event of an issuer default, ahead of bond and equity investors, so recovery rates are generally higher. But the threshold that determines when an issuer is in default has loosened, as the majority of loan issuers have dropped the frequent financial tests—called maintenance covenants—that identify whether they are still in compliance with loan terms. According to S&P Global Market Intelligence’s Leveraged Commentary and Data, as of Oct. 4, 2021, a record 86% of the $1.3 trillion in outstanding U.S. leveraged loans lacked maintenance covenants. This weakens investor protection in the event of default, as S&P Global Market Intelligence studies have shown that loans lacking maintenance covenants have lower recovery rates than loans with better protections.
So, while spiking interest rates are driving investors to bank-loan funds, investors should be cognizant of the liquidity risk and weakened repayment protections characteristic of bank-loan offerings. These aspects could bite investors when market dynamics inevitably change.