In this low interest rate environment it is always tempting to “reach” for yield. And unlike say junk bonds, senior floating-rate bank loans have an added bonus in that the principal is theoretically secure. Or at least way more secure than a regular bond. As these loans are made to companies on extremely short terms, typically no longer than 90 days, the investor can get the best of both worlds during times of rising interest rates. Competitive rates now and in the future, with only the relatively small risk of outright default on the loans during that 90 day (or less) window. And as recently showcased here, there does seem to be a fairly strong argument in their favor:
What is not as well understood is that, in a flat-rate environment, bank loans also outperform the broad bond benchmark. The main reason for the outperformance is the yield advantage that the bank loans provide over the Barclays index. In today’s market, the Barclays index has a current yield to maturity of only 2.5%, which gives the bank-loan index a yield advantage. If we stay in the current flat-yield environment, bank loans look very attractive.
Yes, all of that is indeed true. And every article discusses the downsides (including the one linked), but I sometimes wonder if people are not dismissing some of these risks off hand. This seems to be the general gist of the bullish argument for these senior loan securities:
The only year that bank loans posted a negative return in a recession was 2008, when the bank loan sector lost 29%. Much of that loss was due to the issuance of loans in the leveraged buyout boom of 2006 and 2007. Current bank loans are being issued with a conservative risk profile, one that is more typical of the period before 2006. The highly leveraged investors who drove much of the market volatility have not returned. While a recession will hurt, the bank-loan market looks better prepared today and may even post positive returns in the next recession.
Now, it may very well be true that banks are being more “conservative” with their loans than in 2007. In addition, it is almost assuredly true that because of that, these loans will not be hit as badly as they were in 2008. But is that enough? I’m not sure it is for most investors. One question that pops to mind, is what about the banks themselves? They seem to be up to their old tricks and, of course some argue, compellingly, that the banks’ balance sheets are propped up by the Fed and it is all just an illusion. But, let’s put that whole argument to one side and concentrate on the loans themselves. Even if it’s true that the banks loans are avoiding some of those derivative drenched companies in favor of the more straightforward variety, is that enough? What if the companies that they deal with are in precarious positions? And maybe most importantly of all, what if the next recession is worse than the last one? With this “rebound” being about as tepid as possible, it is hard to argue that the economy is healthy and ready for any downturn. Furthermore, even if all of the things the bulls are saying about this sector is spot on there is still a substantial amount of risk. If another recession hits and you “only” lose say, 15% of your money, are you happy with that investment?
Now, don’t get me wrong, I think that floating-rate paper is a good alternative for some of one’s savings. Generally though, people look at these securities with a more critical eye for safety than they might for a stock fund. There are different risks involved in all investments, of course, but before you decide to hide from the bond market with your “safe” money be careful. It is considered your “safe” money for a reason. It might not be a bad idea to take a look at senior loans and their relatively high yields, but be certain to go in with your eyes wide open. During rising interest rate environments these funds can be truly fantastic. But in a recession the bear will find you even there. And if you think we are in for a bad one, well, these will be little better than a bond fund, and maybe far worse, even if rates continue to rise or stabilize. If rates go down due to any recession, it could get ugly. As I am always babbling on about, it is good to be prepared for everything, good bad or neutral and that goes for senior loans as well as any other investment.