In my new favorite television show of the Great Quarantine,1 the lead character claims that the happiest animal on earth is the goldfish. Why? Because, according to him, the goldfish has a 10-second memory. By that measure, the happiest investors on earth must be the people rushing back into bank loan funds right now.
To be clear, we are not arguing that bank loans are not a good investment. After all, we invest directly in select bank loans in our own portfolios. Nor are we arguing that investors should avoid all bank loan funds. There are some managers that take a careful approach to credit selection who present an opportunity for those who appreciate the differences between a selective credit portfolio and an indexed one. These are the managers that warrant a less tactical allocation within a fixed income portfolio. But make no mistake: Bank loans are credit instruments, and they have often-misunderstood risks which can undermine the very reason they are so popular in the first place.
"Regular readers will recognize that this isn’t the first time we have highlighted hidden risks in the bank loan market. We have written about various reasons to be cautious in previous publications [December 31, 2017: “Running With The Bulls Can Get You Trampled”; February 28, 2018: “This Time It’s Different”; and October 31, 2018: “Covenant Lite: Yields Great, Less (Ful)Filling”]. Shortly thereafter, in Q4 2018, the bank loan market experienced a correction which spooked many investors who didn’t appreciate those very risks and which set in motion a correction in the credit markets as a whole. Notably, many of the risks that went unappreciated at that time are back with a vengeance today.
Bank loans are popular in large part because they are perceived to be floating rate instruments, meaning that if interest rates increase, they are not expected to exhibit the same price declines typical of fixed income securities. In most floating rate securities, when rates go up, the coupons paid to investors also increase. However, as was the case prior to 2018, many loans being originated today have provisions that place a floor on the coupon that will be paid. Often, coupons are reset quarterly, usually at a rate equal to 3-month LIBOR2 plus a fixed credit spread. To protect against a LIBOR rate that is near zero today, many credit agreements stipulate that, if the LIBOR reset rate is below a certain threshold (typically 0.75% or 1%), the reset will use the threshold rate instead of the actual market LIBOR rate. This is, of course, an investor-friendly provision, as the interest paid is higher due to the LIBOR floor.
Let’s take a moment to think about what else this means. Until 3-month LIBOR exceeds 0.75% (at least), the loan will have a fixed coupon rate and behave more like a typical fixed income instrument when interest rates increase for at least that fixed rate portion of the loan’s life. As of the time of writing, 3-month LIBOR is not projected to exceed 0.75% until June 2024. You read that right. More than three years away. To be fair, the markets are not expecting the Federal Reserve to raise their benchmark interest rates for the next two to three years, so this may not be a risk that manifests itself. However, if the goal of loan exposure in a portfolio is to protect against both expected and unexpected increases in interest rates, this is a risk most investors are not aware they are taking.
The hidden risks don’t stop there, and not all of them are as tied to the current market environment as the one we just discussed. Regardless of where interest rates are, many investors forget that bank loans are credit instruments that regularly have long maturities. New loans typically have maturities between 5 and 10 years, and since the credit spread component of a loan’s coupon reset is fixed, the sensitivity to credit spread moves always resembles that of typical fixed income securities. This is referred to as the credit spread duration. Anyone completing due diligence on any credit portfolio should ask the manager for both the interest rate duration and the credit spread duration to fully understand the risks.
In a market where credit spreads have snapped back near their all-time tightest levels, taking on longer-term credit spread duration requires caution. Zeo believes it is irresponsible to take this risk indiscriminately by buying an index fund of bank loans where the underlying credits owned are not proactively chosen by a manager doing fundamental analysis on the issuers. Even many CLOs expose investors to less selective credit portfolios. What is worse, companies can typically repay loans at 100% of their face value at any time. This means that if credit spreads tighten, bank loans do not benefit from the same price appreciation that can be observed in longer-term bonds. In short, the credit risk in loans is not only longer-term than many investors realize, but it is asymmetric to the downside as well.
What can investors do if they still want a portfolio that is less sensitive to interest rates without taking on a suboptimal and possibly lopsided credit exposure? We at Zeo suggest there are two good answers to this question. On the one hand, if the investor is only concerned about the credit risk itself and can accept some price movement due to interest rate fluctuations, look for a carefully researched portfolio rather than an index or a passively managed fund. Fundamental analysis can help mitigate credit risk by reducing the impact of poor-quality credits, which are often disproportionate drivers of credit indices. Such a portfolio could be all loans, but for a bit more diversification, we believe credit strategies, such as Zeo’s, can help further reduce asset class idiosyncrasies of the bank loan market. In the case of our sustainable credit portfolio at Zeo, the native consideration of ESG factors in our investment process (which we believe are core credit factors) further elevates the underlying credit quality despite having some duration exposure, in our view. That said, in our opinion and experience, it is important that any approach to credit is a deeply fundamental one, with the resulting holdings limited in number and truly held to a higher credit standard, not just an index by another name.
For those investors seeking both lower interest rate sensitivity and credit spread exposure, we believe Zeo’s short duration strategy provides the profile investors are seeking from bank loans without the hidden risks we discussed above. Our short interest rate duration profile limits the interest rate risk in the portfolio naturally, without relying on interest rate resets that may not happen for structural reasons. Meanwhile, we explicitly manage our short duration portfolio to avoid an unexpected mismatch between credit spread exposure and interest rate exposure; the credit spread duration in this portfolio is naturally limited by shorter average maturities. Keep in mind that, since this strategy does not have a long-term sensitivity to credit spreads, our short duration portfolios will not behave like longer-term high yield portfolios. This applies to the exposure in both directions, up and down, which we believe is more appropriate than the unexpected asymmetry present in many index-like loan funds.
We are all watching assets flow into passive loan portfolios today at a rate not seen since 2017. Investors would be well-served to remember the last time the overlooked risks of the bank loan asset class reared their heads. In life, it sometimes helps to be a goldfish; a short-term memory can be the key to resilience and longevity. This is emphatically not the case with investment portfolios.
By Venk Reddy
Originally published in Q4 2020 letter
1 If you haven’t had the pleasure of watching the series Ted Lasso on AppleTV+, put down this letter right now and go binge watch the ten-episode first season. William Haemmerle of Wiss & Company (an accounting firm with which we have no relationship) wrote the following on the company’s official blog: “There are certain people we meet throughout our lives that we know will change us forever. They encourage us to become a better version of ourselves. I recently met one of those people while watching the first season of Ted Lasso on AppleTV.” He is spot on. Seriously. Put down this letter and go watch it. Now. (But maybe not with your kids. Fair warning that it can be a little bawdy.)
2 LIBOR is the London Interbank Offered Rate. This is the average rate at which banks in London are willing to lend in US dollars to one another. It is determined by surveying contributing banks daily, throwing out the highest and lowest quartiles and averaging the remaining surveyed rates. Due to a price fixing scandal resulting from collusion among the traders who supply these rates across multiple banks, LIBOR is scheduled to be fully phased out by 2023. The loan market is still trying to figure out how best to handle this. At the moment, the final decision in many credit agreements lies with the issuer and the bank which acts as the administrative agent for the loan. That the lenders themselves don’t seem to be part of this determination strikes us as yet another risk, albeit a small one, that investors should at least be aware of.
Important Disclosure Information
Zeo Capital Advisors is a fundamental investment manager with a short-duration credit mutual fund, a sustainable high yield mutual fund and separately managed accounts. Venk Reddy authored this piece and is the Chief Investment Officer and founded Zeo Capital Advisors in 2009.
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