Since 2009, Leland Hart has been a co-manager of BlackRock’s Floating Rate Income Fund (BFRAX). For the last 3 years, the fund has has an annual return of 9.36% and is rated four out of five stars by Morningstar. I recently had the pleasure of speaking with Leland Hart about floating rate loans and here is what I found out:
LB: What are bank loans and why do all the bank loan funds tend to hold non-investment grade debt?
Hart: Bank loans are contracts, unlike bonds which are securities, which are distributed to banks, institutional investors, and a number of private and public funds. They carry a floating interest rate based on LIBOR and a fixed rate component, usually called a credit spread. Typically, the fixed interest rate is 350 to 650 basis points, depending on the issuer’s credit strength. While there is no reason a bank loan (inside a mutual fund) cannot be investment grade, there is very little appetite amongst institutional investors for a corporate debt instrument that pays LIBOR + 50 – 150 bps. Additionally banks like to keep the high grade loans, as they have more ways of monetizing the relationship with the corporation in terms of ancillary services.
LB: What is unique about investing in floating rate loans?
Hart: From a strategy point of view, you want to focus on avoiding investing in a loan that will default. The upside of investing in bank loans is capped. Bank loans are almost always pre-payable by the borrower at par (face value). In fact, about ⅓ rd of bank loans are pre-paid every year. As a result, bank loans don’t typically trade above par. Since there is very little room to make up for losses with gains, the key is avoiding losses.
LB: Why do bank loans typically pay a lower interest rate than high yield loans that hold debt from similarly rated issuers?
Hart: First of all, bank loans have higher recovery rates than high yield loans (lenders receive more back when a firm goes into bankruptcy) , because of their superior legal standing. A large difference in yield reflects the difference in credit standing. Secondly, the starting point for the loan is different. Bank Loans start off at LIBOR plus a credit spread, while the base rate for high yield is the treasury rate plus a credit spread. LIBOR is currently at around 45 bps and the 10 year treasury is around 1.61%. A difference of over a percent. Lastly, given the current environment of higher rate expectations, there is a meaningful but hard to measure premium for low duration assets like bank loans which don’t lose value when rates rise. Duration is certainly a common concern for investors in this low interest rate environment.
LB: In a rising rate environment which would do better, high yield or bank loan funds?
Hart: It matters why rates were rising. Lets assume that rising rates were a result of inflationary pressure from economic growth. Then the question becomes, where are rates when they start rising and how fast do they rise? Its important to remember that both bank loans and high yield bonds are composed of two components. With high yield bonds, its the risk free rate of return, the treasury rate, and a credit spread. Right now, the overwhelming majority of the yield for junk bonds comes from the credit spread. In this scenario, the impact from improving economic conditions on credits spreads might be greater than the impact of rising rates.
As interest rates rise, all fixed income instruments which pay a fixed coupon lose value if interest rates increase more than credit spreads tighten. However, improving economic conditions would reduce the chances of default and increase recovery rates. The type of economic activity that you might see with a 100 bps rise in interest rates would probably result in reduction in credit spreads by a greater amount. However, if rates continued to rise and the proportion of the overall yield to attributable to credit spreads got smaller, credit spreads would become more resistant to compression. Bottom line, a rise in interest rates right now might lead to lower yields and higher values for junk bond funds.
For bank loan funds, a rise in short-term interest rates would be matched by a rise in the yield paid by the issuer to lenders. As a result, bank loans don’t lose value during rising rates. However, bank loans would not dramatically appreciate in value because of improving economic conditions. While the quality of the loans held by bank funds would have less credit risk, the appreciation is capped by risk of pre-payment at par. Bottom line, the value of bank loans would not move significantly in value from rising rates.
On the other hand, if interest rates were to rise sharply over a short-period of time. This would favor the performance of bank loan funds over high yield funds.
LB: Can you talk about the difference between investing in closed end and open end floating rate loan funds.
Hart: I am involved in both these spaces. Closed end funds can provide potentially higher, but more volatile returns. Closed end funds can employ more leverage than open end funds and can trade at a premium or discount to NAV.
LB: What have I missed during this questions?
Hart: Your questions have been phrased in a way that suggests that investors should be choosing between bank loans and high yield. I think the bigger question is do leveraged loans provide a good investment opportunity. Its a good time to be loaning to corporate America, fundamentals are good and improving. Leveraged loans are paying an attractive yield compared to longer duration fixed income assets. If interest rates don’t rise, investors are earning a nice yield. If they do rise, owners of leveraged loans are in position to benefit in the form of higher rates from bank loans or increased high-yield bond values.
LB: Thank You.