Bank Loan Portfolios: Value Proposition in the Search for Diversification and Yield

by Parijat Cheema, CFA and Daniel Carr
parijat.x.cheema@jpmorgan.com, daniel.p.carr@jpmorgan.com

As global economies continue to muddle through an extended period of low and tentative growth, the issues of optimal asset allocation, diversification, and reduction in portfolio volatility continue to be key themes for investors. The convergence of correlations across asset classes evidenced during the height of the financial crisis brought into question conventional theories on asset allocation, as even well-diversified portfolios suffered sharp declines. In the current low interest rate environment, investors continuously search for diversification and yield as they attempt to structure portfolios that can withstand changing economic scenarios.

In this article we examine bank loans. This asset class has sparked renewed interest among diverse groups of investors including institutional investors and hedge funds. We discuss some of the attributes of bank loans that investors may find suitable for achieving portfolio diversification and yield.

Background – Bank Loans

The bank loan asset class comprises loans made to leveraged issuers whose credit ratings are below investment grade. The loans primarily are first lien or senior-secured debt with priority over other claims in the event of default or bankruptcy of the issuer. Issuers pay spreads above LIBOR to attract interest from banks and other institutional investors. Investments in bank loans can be structured through multiple vehicles including separate accounts, open-end funds, closed-end funds, commingled funds, and Collateralized Loan Obligations (CLOs). Bank loans constituted 45% or $284 billion of the new issuances in the leveraged finance market in 2010.¹ Exhibit 1 provides a snapshot of the significant growth of the bank loan market from 2000 to 2010.

Exhibit 1 — Leveraged Loan Market Size

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Source: Credit Suisse Leveraged Finance Strategy Update, January 2011

The main groups of investors in the bank loan market include banks, finance companies and institutional investors. The institutional investor group includes CLOs and bank loan mutual funds, also known as Prime Funds. CLOs are special purpose vehicles structured to hold and manage pools of loans. The CLOs have several tranches of debt with a varying degree of rights to the collateral and payment streams from the underlying loan pools. Mutual funds investing in bank loans allow access for retail investors to participate in the market.

Why Bank Loans?

As an asset class, bank loans possess multiple characteristics that make them attractive to investors and differentiate them from other fixed income investments. In the following discussion, we examine these attributes in detail.

Interest Rate Risk

Rising interest rates are always a concern for fixed income investors. With current interest rates at all-time lows and the likelihood that they will eventually move upward, bank loans can offer protection due to their floating rates. Bank loans are generally tied to LIBOR or other benchmark rates. The coupons carry a credit spread above LIBOR and reset upwards periodically with increases in LIBOR. Bank loans also offer some downside protection by way of a LIBOR floor. Typical new loan issues include a LIBOR floor of 1.5% - 2% plus a 350 - 450 basis points spread.² If LIBOR falls below a certain threshold, investors receive a minimum LIBOR plus credit spread until LIBOR exceeds the set floor.

As of December 2010 when LIBOR was at 0.3%, BB rated new institutional debt was issued at an average spread of 365 basis points above LIBOR, while B rated institutional debt was issued at an average spread of 472 basis points above LIBOR.³ While other fixed income securities decline with rising rates, the coupons on bank loans reset higher with rising rates.

Bank loans can be used as a defensive investment to offset declines in other fixed income sectors due to increases in interest rates. In Exhibit 2, we compare the returns of bank loans in different rate environments to other fixed income and equity indices. The bank loans asset class is represented by the Credit Suisse Leveraged Loan Index throughout this article. From 2003 to 2010, banks loans have consistently produced positive returns except for 2008. From 2004 to 2006, a period of rising interest rates, bank loans outperformed the broadly diversified Barclays US Aggregate index.

Exhibit 2 — Performance in Different Rate Environments

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Source: Federal Reserve, Barclays, Bloomberg, J.P. Morgan’s Investment Analytics & Consulting Group

Due to their floating-rate nature, bank loans have low duration. As of November 2010, the Credit Suisse Leveraged Loan index had a duration of 0.25 years,⁴compared to 4.70 for the Barclays US Aggregate index and 4.19 for the Barclays US Corporate High Yield index.⁵ This low duration property of bank loans allows investors to effectively lower portfolio duration with an allocation to this asset class.

Volatility Considerations

Historically, bank loans have demonstrated less volatility during different market cycles than traditional high yield debt and equities. In Exhibit 3, we examine the volatility of bank loans compared to other asset classes over a ten year span from 2001 to 2010. This period witnessed different market environments, including an increasing rate environment from 2004-2006 and the financial crisis in 2008-2009. Over the ten year horizon, the volatility of bank loans has been comparable to that of a more broadly diversified global fixed income portfolio represented by Barclays Global Aggregate index, rather than that of equities and high yield debt.

Exhibit 3 — Volatility Comparison

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Source: Federal Reserve, Barclays, Bloomberg, J.P. Morgan’s Investment Analytics & Consulting Group

The relatively low volatility of bank loans compared to high yield debt and equities, combined with the ability to increase coupons in a rising rate environment, makes bank loans effective for hedging interest rate risk as well as for generating alpha.

Opportunity for Diversification

Bank loans can provide diversification when combined with other asset classes. To allocate assets optimally, investors add securities that have low correlations with other asset classes. We analyzed the monthly return correlations of the Credit Suisse Leveraged Loan index with a few representative asset classes over a five year period from 2006 to 2010. As indicated in Exhibit 4, bank loans had negative correlation to some of the fixed income styles, including the broadly diversified Barclays US Aggregate Index. The negative correlation to other fixed income styles indicates the ability of bank loans to further diversify fixed income allocation.

Exhibit 4

Risk / Return Tradeoff

Investors base investment decisions on potential returns as well as potential risks of an asset class. To examine the risk/return profile of bank loans, we analyzed the Sharpe ratios of bank loans compared to other asset classes during a seven year period from 2000 to 2006, prior to the financial crisis (Exhibit 5). We use the Barclays US Treasury Bills (1-3 Month) as a proxy for the risk free rate in our methodology and geometrically linked annualized returns for the different asset class benchmarks and annualized standard deviations. During this period, bank loans produced the highest risk adjusted returns compared to the other traditional asset classes.

Exhibit 5 — Risk-adjusted Returns during Different Market Conditions

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Source: Barclays, Bloomberg, J.P. Morgan’s Investment Analytics & Consulting Group

Using the same approach, for data subsequent to 2008, a period of low interest rates, bank loans had one of the lowest Sharpe ratios among the asset classes in our analysis. It can be inferred that bank loans will typically perform best in a rising interest rate environment, evidenced by the higher risk adjusted returns.

Higher Credit Quality Than High Yield Debt

While bank loans offer protection from rising interest rates, they carry credit risk. The primary credit risks that banks and institutional investors consider when investing in loans are default risk and loss-given-default risk. The credit worthiness of the issuers is similar to that in the case of high yield bonds; however, bank loans have seniority in the capital structure of issuers and priority of claim in case of bankruptcy or default. Bank loans are secured by specific assets pledged as collateral. Bank loan agreements also contain restrictive covenants that can dictate the specific purposes that the funds can be used for, thresholds for capital ratios, and restrictions on further debt issues if the issuer’s debt ratios reach pre-defined limits. Consequently, bank loans in general carry less risk than unsecured high yield debt while offering comparable returns.

Historically, bank loans have had lower default rates and better recovery rates than high yield bonds.⁶ During the ten year period from 2000-2009, the average default rate on bank loans was 3.9% compared to 5.4% for high yield bonds. After topping out at 9.61% as a percentage of principal amount at the end of 2009, the default rate on bank loans fell to 1.87% at the end of 2010.⁷ Bank loans have also demonstrated higher recovery rates than high yield bonds, primarily due to their seniority in the capital structure. Exhibit 6 provides a comparison of recovery rates on bank loans and high yield bonds for the period 2000-2009.

Exhibit 6 — Recovery Rates of Bank Loans vs. High Yield Bonds

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Source: Credit Suisse, RidgeWorth Investments: ‘The Case for Bank Loans in a Rising Rate Environment’

Institutional Manager Performance

Exhibit 7 presents an analysis of performance of institutional managers of bank loan portfolios vis-à-vis the Credit Suisse Leveraged Loan index from 2001-2010. The sample consists of forty eight managers drawn from the eVestment Alliance database. However, not all managers in the sample use this index as their benchmark.

Exhibit 7 — Institutional Bank Loan Manager Performance

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Source: eVestment Alliance, Bloomberg, J.P. Morgan’s Investment Analytics & Consulting Group

From 2001 through the third quarter of 2007, bank loan managers generated stable returns with the median returns exceeding the index in four of the seven years. In our opinion, 2008 and 2009 represented an unprecedented anomaly primarily due to systemic technical reasons.

The years leading up to Q3 2007 witnessed leveraged structures such as CLOs and CDOs entering the loan market with the backdrop of excess market liquidity. The emergence of the credit crisis led to a rapidly tightening credit environment and flight to quality. The ensuing deleveraging led to panic selling of loans by leveraged vehicles. Default rates remained largely contained, and by the end of 2008, some of the weakest loans had exited the market. In 2009, unleveraged capital began flowing back into the market to seize unique opportunities in bank loans. The demand-supply equation tilted towards heavy demand and lower supplies, and consequently, prices rose. Also, a large part of the increase in high yield bond issuance in 2009 was used to pay down outstanding loans, further reducing supplies. The significant dislocations in the bank loan market in 2008 and 2009 primarily caused the wide swings in the returns for the asset class. By 2010, much of the volatility in the market had tailed off. The data indicates that managers of bank loan portfolios have added value over time, evidenced by the higher median returns in seven of the past ten years, notably 2008.

The performance of bank loans over the last three years has been more of an anomaly rather than reflective of a long term trend, in our opinion. The sharp decline in 2008 followed by a snap back in 2009 presented an unprecedented trading opportunity to aggressive investors who bought into this asset class during this period of uncertainty. Historically, bank loans have offered investors stable returns along with the security of seniority of claim in case of issuer default.

We believe bank loans may be attractive from a strategic perspective to hedge interest rate risk and achieve diversification through low correlations with other traditional asset classes. Tactically, they represent an opportunistic as well as a defensive play in a rising rate environment, to generate alpha as well as offset losses in other fixed income sectors. However, they carry considerable credit risk, and investing in this asset class requires rigorous credit research and risk analysis to limit downside exposure. Given the current low rate environment and market expectations of an eventual rate increase, bank loans with their structural diversity could be well positioned to navigate market volatility.

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