Updated May 27, 2017 12:19 a.m. ET
Despite their many positive attributes, it’s getting easier to pick on bank loans.
On the plus side, these securitized loans made to companies rated below investment grade—also known as leveraged loans or senior loans—offer floating rates, so yields should rise as the Federal Reserve boosts interest rates. They are tied to corporations’ financial health, which has been improving, and they have boasted attractive yields of around 4%.
But they haven’t performed well lately. Bank-loan funds are up just 1.6% this year, compared with 4% for junk-bond funds, according to Morningstar. Despite the Fed’s rate hikes, yields on bank loans have fallen as many companies have refinanced their debt at lower rates (see “The Hidden Risks of Bank-Loan Funds,” Feb. 11). Current yields on bank-loan funds are now about 3%.
Recently, concerns about how leveraged loans will hold up in the next recession—whenever that might be—have been mounting. This is an important consideration, since a selling point of the funds is that loans are senior to bonds in a company’s capital structure. When a company defaults, investors in loans generally fare better than investors in bonds. (Stock investors usually get nothing.)
THAT’S STILL TRUE, but recovery rates are falling. Today, about three-quarters of loans are issued as “covenant lite,” meaning that they offer less protection to investors. A new report from Moody’s Investors Service finds first-lien covenant-lite loan recoveries averaged 70 cents on the dollar in the past 10 years, compared to around 80 cents in the past. For most such loans issued in 2016, projected recovery rates are 61 cents.
Weaker loan covenants allow companies to continue operating for longer before a lender can force a default. That means they can keep losing money, leaving less for even senior lenders to recoup in a bankruptcy, explains Marty Fridson, chief investment officer of Lehmann Livian Fridson Advisors.
Default rates remain low due to the healthy economy, but recovery rates can get a lot worse quickly.
Another culprit: Companies are issuing more senior-secured loans, with less junior debt subordinate to it, says Julia Chursin, who wrote the Moody’s report. That means there is a smaller debt cushion that can absorb the losses in a bankruptcy, she notes. Terms like “first lien” or “senior secured” suggest high status, but it’s the company’s debt structure that matters most. “We’ve found that for first-lien covenant-lite loans, where there was no debt cushion, recoveries were really poor,” Chursin says.
WORRIED YET? Consider this: Looser terms are also making it easier for a company to sell or transfer assets that a lender may have considered security for the loan. “It’s known in the market as getting ‘J. Crewed,’ ” says Philip Raciti, a senior portfolio manager at CVC Credit Partners, referring to J. Crew’s December transfer of intellectual property to a subsidiary. Lenders weren’t happy.
Other troubled retailers could make similar moves. “Loans and bonds with loose documents have been very broadly syndicated,” Raciti says. “These provisions aren’t very lender friendly.”
Mutual funds and exchange-traded funds, such as the popular $9.3 billion
(ticker: BKLN), are still buying bank loans. Such funds are still seeing inflows, though they have decelerated from earlier this year. Managers with new cash have to buy the loans available, even if the structure is weak, notes Thomas Byrne of Wealth Strategies & Management.
Krishna Memani, chief investment officer at OppenheimerFunds, still recommends bank loans, noting they do a lot better than bonds in a default, even if recovery rates are falling. “If you’re looking for extra yield,’ he says, “the less-risky way is loans versus high-yield bonds.”
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