Considering Bank Loans? Three Key Considerations

Key Points

  • Bank loan coupon rates are referenced to short-term interest rates, not long-term interest rates.

  • While they are “senior and secured,” bank loans can still default. The loan default rate has been trending lower, however, after peaking in mid-2020.

  • Bank loans are highly correlated to high-yield bonds and the U.S. equity market. Instances of stock market volatility are likely to result in bank loan volatility as well.

Bank loans offer some of the highest yields in the current interest rate environment. We believe their unique characteristics may prevent many investors from considering them, but it may be a mistake to overlook them.

Bank loans, also called “senior loans” or “leveraged loans,” are a type of corporate debt that have a few characteristics that differentiate them from traditional corporate bonds:

  • Sub-investment-grade credit ratings. Bank loans tend to have sub-investment-grade credit ratings, also called “junk” or “high-yield” ratings. Junk ratings are those rated BB+ or below by Standard and Poor’s, or Ba1 or below by Moody’s Investors Services. A sub-investment-grade rating means that the issuer generally has a greater risk of default, so bank loans should always be considered aggressive investments.
  • Floating coupon rates. Bank loan coupon rates are usually based on a short-term reference rate plus a spread. The short-term reference rate is usually the three-month London Interbank Offered Rate, or LIBOR, although that will likely change in the future as LIBOR is set to be retired in a few years. The spread above LIBOR is meant as compensation for the lenders. Since bank loans come with increased risk—keep in mind that they’re junk-rated—investors demand higher yields in case the issuer cannot make timely interest or principal payments.
  • Secured by the issuer’s assets. Bank loans are secured, or collateralized, by the issuer’s assets, like inventory, plant, property, and/or equipment. They are senior in a company’s capital structure, meaning they rank above an issuer’s traditional unsecured bonds. Despite that secured status, bank loans should still be considered risky investments given the aforementioned junk ratings.