Bank loans are typically available to non-bank institutions through primary syndication or secondary market transactions. The US bank loan market is now larger than the US high yield market. The focus of this article is below investment grade bank loans, which are senior in the capital structure and secured by collateral.
Key characteristics of US bank loans:
Floating rate:
Obligations that reset frequently, typically three month LIBOR plus 2 – 4 per cent
Secured Collateral:
Generally provided through a first lien on all or most assets, including the equity of subsidiaries.
Senior:
The issuer’s bonds and equity first lien are subordinated to the bank loans in right of repayment if there is a credit default. In addition, first lien bank loans tend to represent less than 50 per cent of the value of the borrower, which implies that only a significant reduction in the value of the borrower would endanger the principal amount of the loan.
Maturity:
Maturity is typically five to seven years, with some amortisation, although most loans are repaid in full within the first four years as credit circumstances change. Bank loans are usually repayable at par at any time.
Ratings:
Most bank loans are rated by Moody’s and/or S&P.
Implications of bank loan characteristics:
Limited interest rate risk:
The floating rate of interest protects the price of loans from moving as interest rates change; most non-distressed loans stay quite close to par throughout their lives. Practically speaking, loans have a duration approaching zero.
High recovery rates upon default:
Seniority and collateral have a strong effect on default recovery – a recent S&P’s study showed that the median ultimate recovery rate of bank loans from 1989 to 2001 was 100 per cent.
Initial prices upon default are typically lower than 100 per cent, but generally much higher than for bonds of the same issuer.
Low volatility:
Interest rate protection and valuation protection (due to seniority and collateral) help keep loan prices near par most of the time; asset class volatility is much lower than for other major investment categories.
High Sharpe ratio:
Loans have historically produced the highest Sharpe ratio of any major asset category.
Low correlation:
Due to the factors that produce low volatility, loans have extremely low correlation with most asset categories. Correlation is highest with US high yield, but even that is surprisingly low.
