Thoughts on Bank Debt

Photo Credit: Teemu008
Photo Credit: Teemu008

 

I have long said that until an asset class goes through a “failure cycle,” risk-based pricing will be weak toward the assets in question.? One asset class that has become popular of late is bank debt.? Bank debt is a loan to a corporation that typically has first priority to make claims on the company in bankruptcy, ahead of the bondholders, much less the preferred stockholders and the common equity.

Though it is called bank debt, often the loans are arranged by banks and allow others to lend alongside them.? This has become popular among closed-end funds and ETFs like BKLN.? What are the advantages?

  • In the past credit losses have been low, partially because of strong covenants and low availability.
  • The loans have floating rates, so if interest rates rise, you get paid more, assuming the company does not choke on higher interest rates.

Recently a friend wrote me, asking:

Hi David:

Hope everything is well.

Quick investment question, if you don’t mind.

Wanted to get your thoughts on the leveraged loan asset class. From my perspective, there are both positive and negative factors at play currently, e.g., higher interest rates (positive), weaker covenant packages (negative), among other things.

Would love to get your opinion.

He has a decent summary of the situation.? My view is similar to this analysis at Bloomberg.? Underwriters of the loans have become less choosy, and as such have allowed loans to be made with weak covenants.? As a result, more loans have been made,? increasing their size versus bonds at junk-rated corporations.

I can tell you one thing with certainty.? When the losses of this cycle come, it will be decidedly worse than the prior cycles that had light losses.? That is due to the weaker covenants and the increase in the proportion of financing coming from bank debt.? When the debt had more parties taking losses in front of them, their losses were lower.? Even without the change in the covenants, the larger relative size would lead to greater losses.

I summarize it this way: those throwing money into bank debt do so to earn money but not take interest rate risk.? In the process they absorb more credit risk than prior generations of bank debt investors took on.

I have often invested in bank debt in the past, but I am not doing so now.? I think the credit risk is a lot higher than before, and not worth taking the risk in order to get a floating rate for returns.? Instead, I have invested in short-term bond funds with high credit quality.? Less yield, but more security.

3 thoughts on “Thoughts on Bank Debt

  1. Thanks for the thoughts David.

    Any thoughts on the loss levels in a downturn? The sales people on this stuff always point to high historical recoveries, but the capital stack is much fatter now so they will be much higher than historical. That and weaker protections may actually make recoveries far less since whatever covenants there are will be tripped later.

  2. Hi David, I’ve been a reader of your blog for some time and really enjoyed the depth of analysis you present. Given your concerns regarding bank debt above, do you think these apply equally to all floating rate debentures (such as those in FLOT)? FLOT = high fin sector concentration, and market cap waiting structure. I look at how this kind of product has been shoveled into the Advisor channel for some time on high(er) interest rate fears and I want to be contrarian. In addition, even if the coupon adjusts upward should we not be concerned about the underlying ability to pay (higher payments) and falling collateralization ratios (assets on BS down as rates rise for financials)? Thanks again, Andrew

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