Opportunities in Bank Loans

GUY: Before we “Cut to the Chase” on potential opportunities, I thought we should start with the bare basics - Could you provide a general overview of the asset class and some of its terminology.

Matt: That is probably a good place to start. Bank loans are also known as leveraged loans. Prior to around 2000, they were loans granted primarily by banks and that is no longer the case. They are typically, but not always, loans granted to speculative-grade companies – meaning those with a credit rating of BB+ or lower. The loans are typically secured with a lien on the company’s assets – and loans are almost always place in a senior position to bonds in the capital stack. Banks loans typically have a floating rate structured and are priced as spread over LIBOR and lastly they are often structured with shorter maturities than bonds and with more restrictive covenants.

GUY: Another term that I hear being used is Leveraged Finance. Is this because of how the proceeds of the loans are being used?

Matt: Exactly. Quite frequently the proceeds of the loans are used for 4 main purposes: LBO’s, M&A, Recapitalizations, or Refinancing Old Debt. …think “The Bonfires of the Vanities”…. So as you might suspect, Private Equity companies tap the Leverage Loan market frequently.

Let’s go back for a minute to terminology as a reminder to your listener…… Investment grade debt is debt issued by companies rated BBB- and above. They typically have strong credit profiles and very low risk of default. Speculative-grade debt is debt issued by highly leveraged companies and have a riskier credit profile. When it’s in the form of a bond, it is referred to as “junk” or “high yield”. ……maybe the marketplace will rename it “medium yield” soon……..Anyway, if it is in the form is a loan, they are referred to as “leveraged loans”, “bank loans” or given the use of the proceeds, sometimes as “Leveraged Finance”.

GUY: That explanation was helpful. What is the size of the bank loan or leveraged loan market and how does it compare to the high yield bond market?

Matt: The bank loan market, and the corresponding demand for floating-rate structures have grown significantly over the past decade and 2021 issue is on pace for record issuance. The overall market stands at about $1.2 billion which is approximately the same size as the high-yield debt market.

GUY: Is it the floating-rate structure of the interest payments what is driving the appetite?

Matt: That is only part of the story. It certainly helps that inflation and inflationary expectations have been trending higher, because higher inflation tends to lead to higher interest rates that boosts yield on floating rate loans. As expectations rise for central banks to act, short term rates are typically driven higher and we would expect some spread widening to LIBOR. However, with average spreads already in excess of 400 bps above LIBOR that is quite a bit of relative yield pick-up in a low interest rate environment. Despite the speculative grade of bank loan credit, strong economic conditions mean there is little stress in the market right now and default rates remain near historic low.

GUY: Well, I believe you just outline the opportunity and why you like the Bank Loan sector right now: Attractive yield pick-up and low default rates. Are there specific types of issuance or financing structures that you particularly try to look for?

Matt: We prefer issuance that is being used for M&A activity because sometime there are better credit agreements and higher quality companies involved and often times there is no sponsor or Private Equity partner standing in the middle.

GUY: Is the majority of bank loan market in the BB sector?

Matt: Going down the capital structure…….Triple BBB’s are about 7%; Double BB’s are about 23%, single B’s are about 61%. The final category is CCC and unrated loans which include defaulted loans and they represent about 9% of the market.

GUY: What is, if there is one, the biggest misconception about the Bank Loan Market?

Matt: The biggest misconception is that they are inherently safe just because they are secured. If this same firm has no subordinated debt than there is no cushion to draw from first. On top of that loans are callable, so if buy near par, then you’re your upside is basically zero. Lastly, loan protection are not as good as they used to be, in other words, “covenant lite” are more prevalent….meaning that loans have fewer restriction on the borrower and fewer protections for the lender.

GUY: That paints a cautionary even gloomy picture. Are you sure you actually like the sector?

Matt: Ha. I was outlining the nature of the market. I do like the sector, but it’s important that your listeners and potential investors understand the risks and the opportunity set. This is an asset class where partnering with an experienced advisor and portfolio manager is important. There are numerous factors that are critical to understand, such as, how the covenants work…..understanding the industry and companies which is receiving the loan…..what causes spreads to narrow and widen……understanding the factors that typically drives those movements……and how and when to trade around those movement. You never want to sell at an uneconomic price...and there are times when you want to have some dry power to be able deploy at an opportune time. Understanding these nuances, can only come from experience.

GUY: Is it difficult to do your homework and find the loans you want to grant? I ask because I suspect there is less information available to you than you would get with a public company.

Matt: We believe this can be an advantage to those with experience across business cycles and geographic regions. Doing deep bottom- up research is important. Our team has more than 20 years of experience across sectors with some located in Europe and across several regional offices in the US. We have a research team of 35 people. It would be difficult to do the necessary due diligence without them.

Guy: We are out of time today, but I believe that is an excellent place to stop. Thank you for helping me and our listeners to better understand the asset class, it’s terminology and the opportunity set.

Matt: Thank you.

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