Floating-rate bank loans darling of the fixed-income market

With record-low interest rates wreaking havoc on income-seeking investors and the risk of a rate increase growing with each passing day, floating-rate senior bank loans have become the latest darling of bond investors.

A large part of the appeal, which was illustrated by nearly $15 billion pouring into bank loan mutual funds during the first quarter, is the idea that the interest on the loans adjusts to rising interest rates.

The interest on the loans, which are made to businesses by banks, is pegged to the London Interbank Offered Rate.

Although the bank loan category qualifies as below investment grade, it generally is considered higher quality than traditional high-yield bonds, mainly because of the floating-rate feature.

The bank loan funds category, as tracked by Morningstar Inc., gained 9.4% last year, and is up 3.4% this year.

That compares with the Barclays U.S. Aggregate Bond Index, which gained 4.2% last year and is down 0.2% this year.

Although bank loan yields are comparable to those of other high-yield bonds, much of the recent appeal can be traced to the floating-rate component.

But that shouldn't be the only reason to invest in bank loans, according to Mark Okada, co-founder and chief investment officer at Highland Capital Management LP, an $18 billion asset management firm.

“It will be hard to call the exact move in interest rates because we're in a massive global monetary experiment that's never been done before,” he said.

Part of the reason that Mr. Okada likes bank loans has to do with something most people aren't even talking about. About two-thirds of the $1.3 trillion bank loan market is owned by Collateralized Loan Obligation funds, which represents stability.

“The CLOs have 10 years to raise the money, so there's no hot money there,” Mr. Okada said.

In addition to the floor installed by the presence of the CLO market, bank loans also stack up strongly compared with traditional high-yield bonds when it comes to default risk.

The average high-yield bond is rated B, while the average bank loan is rated double-B.

In terms of historical default patterns, the long-term default rate of bank loans is 3%, with an average recovery rate of more than 70%.

High-yield bonds have a long-term average default rate of 4%, with an average recovery rate of 30%.

“Both have default risk, but it's better to be in bank loans than high-yield bonds if you adjust for default risk and recovery,” Mr. Okada said.

To be clear, bank loans are below investment-grade bonds, and should be approached accordingly.

Source:  Jeff Benjamin, Investment News

PowerShares Senior Loan Portfolio (BKLN) is a component of the D2 Capital Management Multi-Asset Income Portfolio.

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