Bank Loan Funds: You Are What You Eat

By Venk Reddy
Originally published in Q4 2017 letter
 

When we started the Zeo journey, we remember having to explain to prospective clients why they might want a shorter duration fixed income strategy in a long-term portfolio. Nowadays, financial industry conferences resemble a Baskin Robbins store of short duration: there seem to be 31 flavors of “we aim to protect your portfolio when interest rates go up”. But, like with ice cream, the ingredients, and how you make it, matter. How a strategy gets to its short duration, and even whether it actually is short duration, is often a function of understanding the component risks of an asset class, what might go wrong and how the manager is mitigating that downside. Most important, it should be simple enough to understand and repeat.¹

Take bank loans, for instance. There is no shortage of mutual funds offering bank loan portfolios as the panacea for all that ails a fixed income portfolio. After all, loans are floating-rate instruments, meaning their coupons increase if interest rates increase. What this means is, as interest rates increase, the value of a loan stays the same because the usual negative impact of a rate rise on bonds is offset by the higher coupon. Sounds great, doesn’t it? We think so – bank loans have been a small portion of our portfolio for years.

True to their billing so far, bank loan funds have performed well over the last few years as well. As rates stabilized and started to inch upwards, the demand for loans has spiked. Loan prices have gone up (and yields have gone down) as a result. Companies have borrowed from loan investors at record levels with some of the least restrictive lending terms the market has ever seen. This, in turn, has contributed to near-zero corporate default rates. But, it’s a seller’s market, and investment banks have noticed. The credit spreads investors are earning for loans has never been tighter, resulting in some of the lowest coupons for corporate debt in history. This has been great for companies and their equity, as stockholders have been among the most rewarded beneficiaries of this historically cheap cost of capital.

What has happened as a result is a noticeable decline in the underlying credit quality of the average outstanding loan. Many loan investors don’t care. After all, loans tend to be the senior- most part of a company’s debt, so the risk of principal loss is perceived to be low regardless. But this is a mistake. Even if the risk of principal loss due to default is low, which is debatable for some of the more popular loans in many large funds, the risk of large price movements is not. Most loans, despite their low interest rate sensitivities, have very high sensitivities to credit spreads, some as long as 5 to 7 years. This is because the coupons of floating rate instruments do not increase when credit spreads increase the way they would for interest rates. The same bond math that has prompted some to flee intermediate- and long-term funds exposes investors in bank loan funds to a rude awakening if credit spreads widen. Unless an investor is willing to commit to not having access to her capital when that happens, any sale during such a decline is as real a principal loss as one caused by a corporate default.

This is not to say that we believe bank loans are too risky for a responsible fixed income allocation. But it does matter that investors know the risks and investment process of the strategy in which they are investing. When evaluating a manager, it is important to know if their approach is deeply fundamental. Put another way, how selective is the process and do they tend to focus on the small minority of debt instruments and issuers whose strong credit profiles offset the supply/ demand impact of the overall market? As many of you have heard us say before, it has been our experience that in portfolios that invest in credit, it matters what credits you pick. Sometimes, this requires avoiding overlap with broad market index mutual funds and ETFs. Such portfolios of bank loans selected using non-fundamental factors or which take an index approach may seem similar, but they are an entirely different flavor with a risk which may be unwelcome – and unnoticed until it’s too late.

Compare that to a truly fundamental approach, in which individual companies are selected and evaluated based on their ability to repay their debt, with the aim of buying the best among them – in short, the vanilla of short duration fixed income, simple and intuitive. But don’t be fooled. Great ice cream of any flavor is hard to make; it should just have ingredients you want and a repeatable recipe. Does anyone really know how they get tutti frutti to taste that way anyway? When it comes to fixed income risk, it may be best to stick to the flavors which are easy to understand and explain.