More Senior Than What? Potential Risks in Senior Bank Loans

by Loren Sageser, Jason Duko of PIMCO, 2/9/17

Floating rate bank loans, which are typically the most senior debt in an issuer’s capital structure, have traditionally been considered more resilient than high yield bonds in the event of default. However, recent shifts in the bank loan market may challenge this historical norm. When a company defaults, position in the capital structure is critical, and recent profile changes among many issuers in the loan market could meaningfully alter recoveries in the next credit downturn.

Standing at the front of the line doesn’t mean much when there is no one behind you; sitting at the senior-most level of the capital structure is less meaningful when there is little or no debt beneath you. Historically, bank loans with greater amounts of subordinate debt typically have seen higher recovery rates (see chart).

Potential recovery, liquidity, transparency

Market-watchers tend to focus on statistics such as covenant-lite loan issuance and leverage levels when gauging risk levels in the loan market. However, surprisingly little ink has been spilled over the growing share of loan-only issuers: Since 2011, loan-only capital structures have risen from 56% to 69% of the total bank loan market, according to LCD. Historical precedent suggests investors in these issuers may receive lower recoveries in the next default cycle.

Beyond the problem of potentially lower recoveries, loan-only issuers present higher risk because of two other important factors: liquidity and transparency.

Loan-only issuers typically issue smaller tranches, which generally leads to lower liquidity levels. PIMCO believes that in today’s market there is generally insufficient compensation (i.e., spread premium) for giving up that liquidity. In addition, when there are outflows from bank loan mutual funds, managers often sell their most liquid loans first, which can lead to an increasing proportion of less liquid loans in these portfolios over time.

Transparency can also be a concern with loan-only issuers, since they tend to provide only limited ongoing reporting. Many of these issuers do not host quarterly conference calls and offer limited management access, reducing the ability of portfolio managers to adequately monitor these investments.

Consider a defensive approach

PIMCO has historically tended to favor bank loans supported by higher levels of capital structure subordination. While this may result in marginally lower potential yield – since loans with greater subordination levels often command premium pricing – there is greater potential for a boost in resiliency during periods of market volatility.

Since the global financial crisis, many areas of the global credit markets have seen notable positive returns. However, now that it’s been nearly eight years since the last default cycle, credit investors may want to consider a more defensive approach by moving higher up in the capital structure. We believe investors should be wary of bank loan strategies that target higher yields by sacrificing capital structure seniority. They may be adding more high yield exposure than they bargained for.

Loren Sageser is a product manager focused on credit investments. Jason Duko is a portfolio manager focused on bank loans.

DISCLOSURES

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Floating rate loans are not traded on an exchange and are subject to significant credit, valuation and liquidity risk. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

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