3 Risks of Investing in Bank Loans
With interest rates rising in the bond market, fixed income investments are losing value. Bank loan yields rise with prevailing rates, but have a few downsides.
Bank loans might be a worthy investment in your overall portfolio. The asset class has a relatively stable return profile, they pay a coupon that rises as interest rates rise (and falls as interest rates fall) and they are the first in line to recover losses if a borrower defaults. But there are risk factors to consider when investing in bank loans.
The advantage of bank loans is that they may lower a plain vanilla portfolio’s overall interest rate risk and volatility. However, being the smart investor you are, you know that no investment is without its trade-offs, and bank loans are no exception. Here are three items to be wary of when considering investing in bank loans.
1. Reinvestment Risk.
Any bond that pays interest is subject to reinvestment risk, the chance that the income paid to the bondholder will provide less yield if prevailing rates go lower. This applies to both fixed rate and floating rate bonds, but it has a larger impact on floating issues such as bank loans. If interest rates fall, then not only do bank loan investors have to reinvest at lower rates, but they also have a smaller and smaller amount to reinvest.
Consider the following hypothetical situation. Someone buys a bank loan when interest rates are at 5 percent, and the following quarter they fall to 4.5 percent. This bank loan investor will need to settle for a half percentage point less on the new investment, and the following quarter there is that much less to reinvest. This becomes a big factor when rates are falling: Smaller amounts of income to invest and lower yields the reduced capital.
2. Liquidity Risk.
The bank loan market has only been around for two decades, so there isn’t a large amount of history within this asset class. The track record so far shows there just aren’t as many buyers and sellers when compared to the high yield market or the investment grade market. Because of the relatively low number of participants, bank loan investors may not be able to find a buyer or seller when they want, even in normal times. In times of stress, especially, it can lead to big price discrepancies for those who wish to buy or sell. The reasoning behind this is straightforward: The laws of supply and demand dictate that when there are more sellers than buyers, like there were in the 2008 stock market collapse, the price of the item will drop. Additionally, illiquid markets are exposed to the risk of significant swings in price whenever an unusually large trade is placed. If a large institution wanted to liquidate a big bank loan position it could put downward pressure on pricing.
3. Non-Normal Returns.
By non-normal, I don’t mean weird or strange. This is actually a fancy statistical way of saying that investors could experience an unusual return, which could be negative or positive. When its a positive return like the 8 percent paid on bank loans in one month back in April of 2009, most people view this as a good thing. But the opposite can occur, as well. For example, in October of 2008, when investors were getting hit with margin calls and were selling out of everything they owned all at once, bank loans dropped by 13.0 percent. That’s rather sizable considering monthly fluctuations are usually more like 0.5 percent to 1.5 percent. The lack of depth in the bank loan market may result in unexpectedly large negative returns.
Despite these downsides, bank loans can be a great diversifier within a portfolio when rates are rising. It depends on how you structure your income portfolio and your willingness to deal with the risk of falling interest rates or being stuck with an asset that can lose value as many buyers disappear in times of stress. I’ll let you weigh the pros and cons.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate please consult your financial advisor prior to investing. All performance referenced is historical and is not guarantee of future results. All indices are unmanaged and may not be invested into directly.
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