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.
For further insights into the bank loan market, please read the PIMCO Viewpoint, “Leveraging Opportunities in Bank Loans to Enhance Return Potential.”
Discover where PIMCO sees opportunities in global credit markets.
Loren Sageser is a product manager focused on credit investments. Jason Duko is a portfolio manager focused on bank loans.