There’s an old market truism that says, “With great turmoil comes great opportunity.” We’re hearing it a lot lately. And investors willing and able to look beyond the short term should be paying attention. For while a fair degree of fear and uncertainty about the market remain, opportunities to generate outsized investment returns over the next five to seven years are becoming more and more plentiful. We’re under no illusion that quick fixes exist for the problems facing the economy and our financial markets, but we’re entirely confident that long-term investors should be looking at opportunities to rebuild their battered portfolios. One asset class that looks particularly enticing right now is the bank loan space.
Bank loans—including floating-rate loans, senior loans and leveraged loans—are loans made to corporate borrowers by banks or other financial institutions. Since borrowers typically carry credit ratings below investment grade, investors in any one issue are subjected to a fair amount of credit risk. That company-specific risk can be diversified away, however, in bank loan mutual funds, which usually invest in hundreds of different loans. Furthermore, bank loans sit in the top tier of the capital structure; in the event that a company defaults, bank loan holders are first in line among creditors. This important feature has resulted in high recovery rates over time: Moody’s Investors Service reports that since 1990, bank loan holders have received, on average, 71 cents on the dollar for defaulted loans. That compares with 57 cents for senior secured bonds, 43 cents for senior unsecured bonds and 35 cents for subordinated debt.
Another substantial benefit to investors is that bank loans are largely shielded from interest-rate risk. Interest rates—often tied to LIBOR—are typically reset every 60 to 90 days, which keeps their effective durations very low. This could be a particularly valuable distinction if government efforts to stimulate the economy eventually lead to inflation and increasing interest rates.
But what is it about the current environment that makes bank loans so attractive? After all, over the years they have been a relatively sleepy category. In fact, between 1992 and 2007, the asset class never posted a negative calendar year return and, relative to the Credit Suisse Leveraged Loan Index, did so with less volatility than the broader bond market. What makes bank loans so interesting right now is what happened in 2008.
Indeed, everything about the bank loan space changed last year as the full weight of the credit crisis hit. Forced selling by leveraged investors, hedge funds and collateralized loan obligations not only sent demand into a tailspin, but added to an already bulging supply backlog. The result for this previously sleepy asset class was a staggering loss of almost 29% for the year. In the process, the average bid price for loans within the S&P/LSTA U.S. Leveraged Loan 100 Index went from around 94 cents on the dollar at the beginning of 2008 to near 63 cents currently. And therein lies the opportunity: Not only will investors have some protection against inflation with the reset feature, they should benefit from greatly depressed prices leading to substantial capital appreciation.
That’s not to say an investment in the space is without risk. As is plainly evident from 2008, the asset class is not immune to significant loss of principal. Nonetheless, a conservative approach to bank loans emphasizing fundamental credit analysis, broad diversification and solid due diligence offers investors a very attractive risk/reward opportunity right now.
J. Gibson Watson III is president and CEO of Denver-based Prima Capital (www.primacapital.com) which conducts objective research and due diligence on SMAs, mutual funds, ETFs and alternatives.