Bank loans have floating coupon rates. Given the Federal Reserve’s recent shift toward easier monetary policies, income payments are unlikely to rise any time soon, while the risk of coupon rates falling further has risen.
Price appreciation is limited. Bank loan prices are near their post-crisis peaks, so it’s unlikely they rise much further.
The quality of loan covenants, which are meant to protect investors, continues to deteriorate. This trend could lead to sharp price declines if market conditions deteriorate.
Investors may want to tread carefully in the bank loan market today. Despite a strong performance through the first seven months of the year—the S&P/LSTA Leveraged Loan 100 Index has posted a year-to-date total return of 7.9% through the end of July—it’s unlikely that the strong pace of returns will continue. In fact, bank loan investors now face three headwinds: the potential for lower income payments, limited room for price appreciation and deteriorating covenant quality.
What are bank loans?
Bank loans are a type of corporate debt. They are often called leveraged loans or senior loans, as well. They have a few key characteristics that differentiate them from traditional bonds:
Sub-investment-grade credit ratings. Bank loans tend to have sub-investment-grade credit ratings, also called “junk” or “high-yield” ratings. Junk ratings are those rated BB+ or below by Standard and Poor’s or Ba1 or below by Moody’s Investors Service. A sub-investment-grade rating means that the issuer generally has a greater risk of default, so bank loans should always be considered aggressive investments.
Floating coupon rates. Bank loan coupon rates usually are based on a short-term reference rate plus a spread. The short-term reference rate is usually the three-month London Interbank Offered Rate, or LIBOR, although that will likely change in the future as LIBOR is set to be retired in a few years. The spread above LIBOR is meant as compensation for the lenders. Because bank loans come with increased risk—keep in mind that they’re junk-rated—investors demand higher yields in case the issuer cannot make timely interest or principal payments.
Secured by the issuer’s assets. Bank loans are secured, or collateralized, by the issuer’s assets, like inventory, plant, property or equipment. They are senior in a firm’s capital structure, meaning they rank above an issuer’s traditional unsecured bonds. But don’t confuse “senior and secured” with “safe.” Bank loans still can, and do, default—just like traditional corporate bonds. In fact, the trailing 12-month loan default rate was 2.4% through June 2019, only slightly lower than the 3% default rate for U.S. high-yield corporate bonds, according to Moody’s.1
Three warning signs for the bank loan market
Risks are rising in the corporate bond market—and that includes bank loans. Slowing corporate profit growth, global growth concerns, and the slope of the yield curve are all risks that could to lead to lower corporate bond prices. However, we see three risks that are specific to bank loans:
1. Income payment trajectory. Federal Reserve policies can drive the direction of bank loan coupon rates, as three-month LIBOR is highly correlated with the federal funds rate. As the Fed began to shift its policy stance and hint that rate hikes might shift to rate cuts, three-month LIBOR dropped.
票息收益的波动方向。美联储的货币政策会决定美国银行贷款票息率的走势，因为3个月 LIBOR与联邦基金利率的走势高度相关。因联储货币政策立场开始转向并暗示将从加息转向降息，3个月 LIBOR的水平出现下跌。
The Fed cut its benchmark interest rate at its July 30-31, 2019, meeting. While the statement and Fed Chair Jerome Powell’s remarks during a press conference that followed were a bit ambiguous about the future path of monetary policy, markets are still pricing in more cuts. According to Bloomberg, there’s a 100% probability of a cut at the September meeting, and the fed funds futures market is still pricing in three to four more cuts by the end of 2020.2
Given market expectations, as well as Fed projections from its June meeting, it’s unlikely that LIBOR rates will move higher anytime soon, with a greater risk of rates falling. That means bank loan coupon payments are likely to fall further.
The reference rate for bank loan coupons may continue to fall
Source: Bloomberg, using weekly data as of 7/31/2019. ICE LIBOR USD 3 Month (US0003M Index).
2. Limited price appreciation. Bank loan prices are high and there’s little room for prices to rise much further. The average price of the S&P/LSTA U.S. Leveraged Loan 100 Index closed July at $98.2, not far off the 10-year high of $99.2.
It’s rare for bank loan prices to rise above $100 par value due to limited call protection—the last time the average price of the index rose above $100 was in June 2007. If a security is “callable,” as bank loans are, they can be redeemed by the issuer before the stated maturity date. Most bank loans have very limited call protection, meaning they can be redeemed and refinanced relatively quickly. That limited call protection generally puts a cap on how high prices may rise. If prices rise high enough, an issuer likely will just refinance the loan with a new loan with a lower spread.
Given the high price of the index, it’s unlikely that prices will rise much further. Through the end of the year, income payments, not price appreciation, should be a key driver of total returns.
Leveraged loan prices are near a 10-year high
Source: Bloomberg, using weekly data as of 7/31/2019. S&P/LSTA U.S. Leveraged Loan 100 Index (SPBDLLB Index). Past performance is no guarantee of future results.
3. Deteriorating covenant quality. A bond covenant is a set of terms, defined in the bond’s prospectus, which outlines what the issuing firm can or can’t do with regard to its business. Lately, loans simply haven’t included many covenants that can help protect investors. Moody’s Investors Service tracks loan covenants, and its “Covenant Quality Indicator” remains near its all-time weakest level.3 Without strict covenants, firms can engage in riskier business practices, like taking on more debt or even selling profitable parts of the business (for a one-time gain), essentially removing a potentially stable provider of cash flows that can be used to repay its debts.
Deteriorating covenants can have a negative impact when we begin to see a rise in corporate defaults. Because the absence of covenants allows firms to engage in more risky business activities, there may be less value in a given company if it were to default, leading to lower recovery rates. (Recovery is the amount that a bondholder ultimately receives from holding a defaulted bond or loan.)
While our discussion above pointed to limited upside in prices, this trend in covenant quality could actually lead to sharp price declines. If growth slows and corporate earnings deteriorate, corporate defaults may rise and loan prices may fall sharply.
What to do now
Bank loan returns going forward are unlikely to match their strong year-to-date total returns, and we see a greater risk of price declines. While the higher yields they offer might seem tempting in a low-interest-rate world, those higher yields are accompanied by higher risks. And with the shift in Federal Reserve policy, bank loan coupon payments may continue to decline.
Keep in mind that bank loans are aggressive investments regardless of the economic or interest-rate outlook. Their prices can be volatile and are subject to sharp drops, a key consideration when making an investment decision. With interest rates trending lower and a greater likelihood of price declines, we suggest investors take a cautious approach, and we would not suggest adding to positions today.
1 Source: Moody’s, “June 2019 Default Report,” July 9, 2019.
2 Source: Bloomberg, as of 8/2/2019. World Interest Rate Probability (WIRP).
3 Moody’s Investors Service, “North American Covenant Quality Indicator, CQI, flirts with record worst as volume surpasses long-term average,” July 9, 2019.