Are Bank-Loan Investors Getting What They Bargained For?

Investors who chose high-yield bank loans over high-yield bonds earlier this year, expecting to be insulated against rising rates, might be surprised to find that bonds might have worked out better.

While the 10-year US Treasury yield rose about 80 basis points from January 2 through November 1, bank loans’ floating interest rate—much touted as a benefit—has actually been a detriment.

As we’ve pointed out, investors who rushed into bank loans in recent years may not have fully considered the potential risks, which can outweigh the perceived benefits, such as loans’ floating rate feature, their seniority in an issuer’s capital structure in the event of bankruptcy and the perception that loans offer a better yield than most other investments. Now, a host of other concerns have arisen:

A staggering number of loans are being refinanced—and issuers hold the cards. The bank-loan market has seen record refinancings simply because issuers can get better rates. Approximately $300 billion in loans—nearly 50% of the outstanding market—have been refinanced since the start of 2012. Issuers have saved an average of 1.2% in annualized interest costs in a sellers’ market that lets issuers refinance whenever they want. Loan investors, on the other hand, have gotten the short end of the stick, with ever-contracting spreads.

The high-yield bank-loan space is underperforming. Despite the continuing demand for bank loans and months of outperformance, high-yield bonds—especially the low-volatility portion of the market—have still outperformed year to date (display). Why is that? Narrowing credit spreads and improving credit conditions have caused high-yield bonds to appreciate in price, while many loans have been repriced at lower rates.

Lower-volatility high-yield bonds—with less duration and higher credit quality—have been in a sweet spot, benefiting from both improving credit trends and a level of insulation from rising rates. In fact, only CCC bonds (not shown) have had meaningfully higher returns in the high-yield market. However, CCC bonds contain significantly more credit risk.

Despite Rising Rates, Loans Have Underperformed High Yield Regulations are spooking some investors. While investors’ interest in individual bank loans has increased, demand from issuers of collateralized loan obligations (CLOs)—loans packaged together and issued with varying degrees of risk and yield—has recently started to slow. Concerns about the proposed Dodd-Frank requirement on risk retention and the lack of available arbitrage have lowered CLO issuance, and until the regulation is finalized, it’s unclear what the demand will be for loans from CLOs.

The Fed appears to be wary of bank loans, too. The US Federal Reserve and the Office of the Comptroller of the Currency are said to have issued a warning recently that asked banks to strengthen their underwriting standards for bank loans. The warning referred to loans they view as deficient—a result of poor-quality underwriting—that could potentially lead to losses. Forty-two percent of leveraged loans were listed in this category.

What does all this mean for investors?

High-yield bank loans have underperformed high-yield bonds this year despite rising interest rates, and we expect this to hold true unless the Fed starts to raise rates aggressively. For investors concerned about rising rates, we think it makes more sense to consider higher-quality, shorter-duration high-yield bonds. These bonds have more call protection than high-yield loans and are likely to be less sensitive to interest-rate fluctuations than longer-term bonds are. They offer higher credit quality than both the broad high-yield market and the loan market; this may also provide better protection against unforeseen crises.

We still believe that high-yield bank loans can be a part of a well-diversified fixed-income portfolio, but diving into the market head first doesn’t make sense to us in this environment. Investors should take a long look at what happened recently to many who took the dive…and found themselves in shallower water than they had hoped for.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Ashish Shah

Chief Investment Officer—Global Credit; Head—Fixed Income
Ashish Shah is Chief Investment Officer of Global Credit and Head of Fixed Income for AB. He is also a Partner of the firm. As CIO of Global Credit, Shah oversees all of AB’s credit-related strategies, including all global and regional investment-grade and high-yield strategies. In this capacity, he leads AB’s internal Credit Research Review Committee, the primary investment policy and decision-making committee for all credit-related portfolios managed by AB. As Head of Fixed Income, Shah is responsible for the management and strategic growth of the overall business. He is the author of several published papers and blogs, including those highlighting high-yield bonds as attractive substitutes for equities (June 2015), concerns around the bank loan market (November 2013) and the dangers in reaching for yield in the high-yield market (August 2013). Shah joined AB in 2010 as the firm’s head of Global Credit. Prior to that, he was a managing director and head of Global Credit Strategy at Barclays Capital (2008–2010), where he was responsible for the High Grade, High Yield, Structured Credit and Municipal Strategy groups and the Special Situations Research team. From 2003 to 2008, Shah was the head of Credit Strategy at Lehman Brothers, leading the Structured Credit/CDO and Credit Strategy groups and covering the cash bond, credit derivatives and CDO product areas for global credit investors. He holds a BS in economics from the Wharton School of the University of Pennsylvania. Location: New York

Ivan Rudolph-Shabinsky, CFA

Portfolio Manager—Credit
Ivan Rudolph-Shabinsky is a Senior Vice President and Credit Portfolio Manager, focusing primarily on the Low Volatility High Yield Strategy and the Short Duration High Yield Fund on the Luxembourg-domiciled fund platform, designed for non-US investors. He is a member of the Credit and High Yield fixed-income portfolio-management teams, and a member of the internal Credit Research Review Committee, the primary investment policy and decision-making committee for all AB’s credit-related portfolios. Rudolph-Shabinsky joined the firm in 1992 as a portfolio manager, and managed the Stable Value and Inflation-Linked Bond strategies. He has held other leadership posts at the firm, including head of Product Development and head of Product Management. Rudolph-Shabinsky has also authored or co-authored a number of papers, including “Beyond Interest Rate Anticipation: Strategies for Adding Value in Fixed Income” (2000) and “Assigning a Duration to Inflation-Protected Bonds” (1999), both published in the Financial Analysts Journal. He also co-wrote “Managed Synthetics,” published in The Handbook of Stable Value Investments (1998), and “LDI: Reducing Downside Risk with Global Bonds” (2012), published in The Journal of Investing. Rudolph-Shabinsky has written many blogs highlighting the risks in bank loans and in high-yield CCC-rated bonds. He holds a BA in economics and Soviet/East European studies from Cornell University and an MBA from Columbia University, and is a CFA charterholder. Location: New York

Related Posts