The absolute return qualities of bank loan portfolios come mainly from their near-zero duration and principal value support provided by seniority and collateral. Floating rates largely eliminate interest rate-related price volatility – a major challenge particularly in the face of rising rates. The minimal interest rate risk and collateral coverage of below investment grade bank loans translates into exceptional returns per unit of risk; the Sharpe ratio is higher than any other major asset class and bank loans typically have low correlation with other asset classes.
Figure one underscores the absolute nature of bank loans. Since Credit Suisse First Boston began tracking them in 1992, the asset class has yet to experience a negative calendar year return. This occurred in a period that included significant economic turbulence and the addition of a new and perhaps permanent level of geopolitical risk.
Positioning bank loans
Bank loans represent an interesting long-term asset allocation choice for investors that seek consistently positive returns. They have earned an enviable place on the market line through high Sharpe ratio and low correlation, as shown by figure two. Bank loans can also be used tactically, to simply outperform other asset categories under certain circumstances. For example, when interest rates are rising, loan returns should increase as Libor rises. Alternatively, investors expecting difficult credit conditions (or merely wishing to reduce their risk in advance of the possibility of declining credit conditions) can use loans to outperform more credit-sensitive strategies, such as high yield. The seniority and collateral of bank loans help protect loan prices as asset valuations decline in difficult credit conditions, whereas the subordinated capital classes of the same borrowers (i.e., bonds and equity) are usually the first to find their prices declining.
Strong in the face of risk
Bank loans could experience price decreases for very basic reasons. Fundamental factors include economic stress, with its implication of higher default rates, as well as geopolitical shock, which can raise fears of economic decline (sometimes with good cause, as seen after 9/11). Technical factors include valuation among competing asset classes, the degree of leveraged money pursuing the asset class and the desire of structured vehicles to use the asset class.
The period from 1998 through 2002 was the most difficult for loans, stemming from problems in Asia, Russia, the internet/telecom bubble, Long Term Capital Management, 9/11 and the US recession, along with frequent concern about persistent asset deflation. During this period, the general trend of Libor was negative and there were significant outflows from retail bank loan funds as investors reacted to unsatisfactory performance in the wake of the telecom meltdown. This period was the worst of all worlds for loans, the ‘perfect storm’ as it was called, with high yield default and distress rates hitting all time high levels amid a series of shocks that undermined confidence in financial markets. The strength of the bank loan asset class was confirmed in this period, as it perpetuated its positive return dynamics.
Therefore, only genuine default risk and associated risk of lost principal should greatly affect the value of a loan. In other words, senior, secured, floating rate loans to good credits (where the loan is a modest portion of the capital structure) will tend to pay off in a relatively predictable manner, which in turn should rein in the desire to trade loans at uneconomic prices.
Levering bank loans
The attributes of the bank loan asset class are conducive to the use of leverage. The low volatility of bank loans and their history of consistent positive returns present a compelling argument to add leverage to a portfolio of loans over the long run. The 13 years of positive returns for the asset class would have included eight years in which returns benefited from leverage, while in the other five years the negative effects were relatively minor, as shown in figure three.
Loomis sayles’ approach
IXIS Asset Management’s US affiliate, Loomis, Sayles & Company, is typically conservative in its approach to managing bank loan assets because its clients demand a high Sharpe ratio. A loan value coverage discipline is employed and, using internal credit research resources, the team makes credit quality observations in evaluating default probability. The team generally favours BB rated loans, which have offered the best combination of risk and return in the bank loan market over time. Purchased loans represent first liens on collateral trading at a fair yield near par. The managers avoid investment grade loans, which are typically low yielding and unsecured, and also generally avoid distressed loans and second liens, where risk/return dynamics may not be advantageous.
The return impact from the negative skew of price potential for the bank loan asset class is much greater than for the high yield asset class. That is, most of the potential price movement from new issue over the life of a loan is downwards, given that few loans will trade over 102 due to lack of call protection and short effective lives. Compared with the high yield market, there are relatively limited opportunities to buy low/sell high. The team believes the most obvious way to outperform the asset class in the long term is to have better quality loans that are less likely to have large downward price movements when credit conditions deteriorate. It is critical, then, to have the credit call right as price changes can quickly overtake a yield advantage.
Kevin Perry is vice president, portfolio manager at Loomis, Sayles & Company, L.P., an affiliate of IXIS Asset Management.
