The rise and fall of bank loan funds
Bank loan funds have had a tough time. The Morningstar category has undergone capital outflows since late 2018, and after the massive sell-off in March 2020, it has fallen to its smallest size since 2012. And the category’s narrow yield spread – a function of loan bonds with the lowest short-term funds. interest rates and a limited hike due to call risk – mean fees consume a larger percentage of returns than in many other categories and make it difficult for individual funds to separate from the pack.
Meanwhile, the bank lending market itself has moved in a direction that has reduced its traditional role as a credit sensitive asset with more resilience than high yield bonds. In fact, the traditional protection of the bank lending industry against high yield bonds has been eroding for some time. More than ever, investors in bank lending must ask themselves what to expect from their allocation and whether bank lending funds are still able to provide it.
Go with the flow
Leverage bank loans conditioned for investors in closed funds and then interval structured funds have been around for decades, but bank loan mutual funds with daily cash are still a relatively new phenomenon. Since bank loans are not securities in a legal sense and the process of negotiating them is more cumbersome, they tend to be significantly less liquid than most other fixed income sectors, making their investment in daily liquidity vehicles a delicate proposition. Over time, market growth and audience expansion, combined with syndication and arm’s length pricing, allowed their entry into the open world, although their relatively less liquid profile remains.
Comprising both exchange-traded funds and open-ended mutual funds, the bank loan category remained a relatively small niche market until 2013, when fears of rising interest rates took hold. resulted in a deluge of influx. Bank loans pay a floating coupon historically tied to Libor (a commonly used short-term institutional rate that is currently phased out in favor of others), so the simple logic was that if rates went up, so would payments. , and the prices would remain stable.
This feature of floating coupons sets bank loans apart from most fixed income markets, and for a short time bank loan funds were the darling of the investment world. Investors invested more than $ 67 billion in the category in 2013, and its size effectively doubled to $ 143 billion at the end of this year, from $ 72 billion at the end of 2012. The assets of the category briefly eclipsed $ 150 billion in early 2014, but the years since then there has been a long descent to 2012 levels.
What is behind this drop? First, the rise in interest rates did not materialize much longer than expected, while in 2014 and 2015 a bear market driven by commodities showed investors that the category was not immune to credit volatility. Leverage loans are a priority in a company’s capital structure, but are generally granted to borrowers who are at risk and invariably vulnerable during a credit crisis. After injecting so much money in 2013, investors withdrew $ 20 billion from the category in 2014 and 2015.
The rate hike did materialize at the end of 2016, and it continued through 2017 and most of 2018. This led to a strong performance of bank loan funds while previously tiny payments. began to rise as the market reacted to improving borrower credit fundamentals.
Another defining characteristic of bank loans, however, is the lack of protection against calls. With almost no preconditions, bank loans can be refinanced at or near par to lower their interest charges. The ease of doing this has traditionally been a function of improving a borrower’s credit profile, but when there is significant demand and banks are keen to collect commissions, borrowers can negotiate deals that are better for them. them as for investors.
This is important because it limits the potential for increased bank lending. Corporate bonds, whether investment grade or high yield, usually come with buy protections or resale features that make it easier for them to trade above face value, thereby increasing their yield. total potential. But callability means that the rise in bank lending is generally capped, while the rise in bonds is not, so improving economic fundamentals – which tend to follow rising rates in the short term – cannot. go that far in terms of rising the price of a loan. For example, around 70% of bank loan issuance activity in 2017 was used to refinance or revalue existing loans.
Rising interest rates – the main reason bank loans are presented as an investment – became a moot point at the end of 2018. The Federal Reserve had aggressively raised rates throughout 2018 until then. that the perceived stress on the economy leads to a short but violent sell-off. in the fourth quarter. In early 2019, just days after the New Year, the Fed reversed course and began a cycle of rate cuts. This blew up the main thesis of holding bank loan funds, and since then the category has seen massive and consistent outflows.
The category recorded $ 36 billion in releases in 2019, its worst year on record; which represented around 28% of assets since the start of the year.
A changing market leads to lower recoveries
There is also reason to believe that the traditional downside protection for bank loans will not be as strong in the future. The huge demand for loans has fostered incredible growth over the years: in 2003 the total loan market was $ 148 billion, in 2008 it reached $ 600 billion and in 2017 it broke the bar. of the $ 1 trillion. Private equity was booming as lending became an increasingly popular way to structure buyback transactions, leading to an increase in supply, while the rapid growth of secured loan obligations fueled demand. Indeed, the CLO market – which brings together pools of securitized loans that are then divided into tranches much like a mortgage-backed security – has grown from $ 19 billion in issues in 2003 to $ 277 billion. issued in 2018. In 2019, the total CLO market was around $ 600 billion, or about half the size of the loan market.
Of course, the massive growth in supply and demand paved the way for a relaxation of credit criteria. As a result, a growing percentage of the market is now made up of covenant lite and loan-only capital structures. The former are loans with limited protection for lenders, while the latter are companies that do not have a “traditional” capital structure comprising investors in bonds and stocks with capital at risk before holders of bonds. ready. Since loans have priority over obligations in the capital structure, they should come out of bankruptcy restructurings with much higher recovery rates.
According to JP Morgan, covenant-lite loans made up nearly 84% of the universe of outstanding loans, as measured by the JPMorgan Leveraged Loan Index. Prior to 2013, covenant-lite exposure was consistently below 20% of the market, but since this year it has accounted for the majority of new issue volume, peaking in 2018 at 87% of issues. At the same time, three quarters of loan issuers are now only loans, compared to a quarter in 2008. These developments have important implications.
The biggest problem is the much lower recovery rate. According to JP Morgan, the collection rate on senior bank loans fell to 48% in 2019, its lowest level on record. Examining the data comparing loans that are based on capital structures that have at least subordinate obligations compared to those on loan-only agreements tells a similar story. In 2019, the first loan recovery rate was 56%, while the senior loan recovery rate was 43%. Indeed, since 2008, loan and bond structures have systematically recovered more than loan capital structures alone.
As you can see in the illustration above, collection rates have fallen sharply across the board since the market began to expand in 2013. This is a drastic change in the overall structure of the business. A loan market that provided recovery rates of 88% in 2004. Implications for the loan market – A worsening decline combined with a capped rise is not an attractive investment proposition.
All of this means that bank loan funds are in a tough spot. If capital outflows continue, the category is likely to experience liquidations or mergers as asset managers have closed unprofitable products. The growth in supply and demand has brought about changes that have weakened the traditional protection of the sector against downturn. And the lack of call protection will remain a hindrance to upward performance whenever credit markets recover, especially in a world of near zero interest rates that neutralizes one of the defining characteristics of the industry. and yield generators. Considering the drawbacks the category faces, only the highest level of team and approach – and low fees – can be expected to outperform.