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Not so fast: Don’t bail on bank loans

JIM TRACY 13-Feb-2019

In the risk-off environment late last year, retail investors may have overlooked the fundamentals of the bank loan asset class.


For a spell, it looked as if the bank loan asset class was immune to the volatility that rocked the rest of the market, but all that changed in late October when an exodus by retail investors accelerated. This culminated in a record-setting $3.5 billion in outflows for the one-week period ending December 26, 2018. The selling pressure led to a steep decline for the S&P/LSTA Leveraged Loan Index1, which declined 3.5% during the fourth quarter. Based on fundamentals, however, we believe that investor fears may have been overblown. 


Investor concerns were triggered by a seemingly endless series of negative articles in the financial press that cited rising leverage, looser credit agreements, and other worries stemming from too much demand chasing too little supply, which theoretically would give borrowers the upper hand in negotiating loan terms. Adding to this was an expectation that short-term interest rate increases could slow, and movements in Treasury yields were interpreted by investors as an indication that a recession was more likely. 


Not so fast. From our vantage, the fundamentals of bank loans look strong. The trailing-12-month loan default rate fell to 1.6% from 1.8% during the fourth quarter, and it remains well below the historical average of 3.0%, according to S&P Global Market Intelligence. Moreover, we look back over the past decade to see that there have been two similar sharp declines in the asset class (as measured by the in the S&P/LSTA Leveraged Loan Index), one in August 2011 and another between May 2015 and February 2016. In each of these instances, bank loans recovered in robust fashion during the following six- and 12-month time frames. 


Of course we all know that past performance is no guarantee of future results. Yet we believe that the S&P/LSTA Leveraged Loan Index may be poised for a rebound heading into 2019. For starters, we expect the U.S. Federal Reserve to raise the federal funds rate once or twice in 2019. Rates on floating rate loans are generally pegged to the London interbank offer rate (LIBOR), and we currently expect 3-month LIBOR between 3% and 3.25% by the end of 2019. These moves will, of course, be contingent on future economic data.


There has been some concern that the end of the credit cycle is nearing, which could lead to a spike in defaults and attendant credit losses. But if corporate treasurers learned anything from the last credit crisis it was not to be cavalier about looming maturities. When liquidity disappeared in 2008/2009, some companies were forced to file for bankruptcy protection simply because they couldn’t refinance their debt, as they had been routinely doing. Since then, we believe that corporate treasurers have been more careful to push scheduled maturities, known as the maturity wall, into the future by continually refinancing well ahead of maturity dates.


All told, the fourth quarter decline in bank loans appears to have been a technical correction driven by retail investors fleeing the market. It also may have been exacerbated by seasonal factors since the final two weeks of December are traditionally are the least liquid time in the market. We believe that liquidity for the asset class remains abundant, cash flow coverage of interest is ample, and maturities are a non-issue. Accordingly, we expect this favorable environment to continue into 2020, and we continue to believe that floating rate bank loans remain an integral component of an investor’s well-balanced fixed income portfolio.