A bond is essentially a loan made by a lender (considered to be an investor) to a borrower who is typically a corporation or a government entity.
The interest rate paid for the loan is locked in for a period of time and is determined by various market factors. The two components of risk related to investing in a bond are the interest rate risk and the default risk.
Lenders and borrowers are diametrically affected when interest rates change. Lenders who are locked in at a fixed rate for a period of time want the rates to stay the same or go down.
If you are a borrower, you don't mind if they go up, because you are locked in at a lower rate. Because interest rates are continually changing, the value of the loans also changes, having a direct opposite effect on the lenders and borrowers.
To mitigate the effect that interest rates have on a lender, a loan may be structured with a variable interest rate,
which moves in tandem with prevailing market interest rates. Most commercial loans have a variable interest rate component, typically tied to the Libor, or the London interbank offered rate,
Variable rate loans generally neutralize interest rate risk, leaving the primary risk to be borrower default.
Investors that want to reduce interest rate risk and capture a higher yield might consider adding senior bank loan securities to their bond portfolio. With a low correlation to Treasuries and other fixed-rate investments, senior bank loans can provide diversification to an investment portfolio. Senior loans are sometimes referred to as "leveraged loans" because, by borrowing, a company is adding leverage to its balance sheet.
The bank loan market consists of loans made to businesses with credit ratings that are generally below investment grade. They are usually secured by the assets of the company and ranked first in priority of payment in the capital structure.
According to S&P Leveraged Commentary & Data, the market is about $515 billion, or about 35 percent of the total speculative grade market.
About $12 billion in retail assets flowed into bank loan mutual funds in 2010, garnering roughly the same flow as high yield bonds.
Senior bank loans are senior to all other debt and secured by the assets of the borrower, which can be everything from cash and accounts receivable to inventory, buildings and intellectual property. Corporate debt such as bonds, preferred stock and convertible shares are always subordinate to senior loans.
In the case of bankruptcy liquidation, the senior loan is first in line. The historic recovery rate for senior loans in liquidation is 70 cents on the dollar, much higher than unsecured bonds, which have a recovery rate of 40 percent.
Current yields on these securities are compelling. A number of these loans have Libor floors of about 2 percent, plus 3.5 percent to 4.5 percent of spread premium, so investors can capture a 5.0 percent to 6.5 percent coupon with more upside if rates rise.
For mutual funds that specialize in purchasing senior bank loans, management skill can make a big difference in the performance of the fund. When investing in a speculative-grade market, it is important that management have a bias for high-quality investments and a track record of low defaults. Industry diversification in a loan portfolio is also important.
Rather than looking for companies that focus on increasing shareholder returns, bank loan fund managers should be more interested in companies that are striving to reduce leverage and improve credit quality. Loan covenants should play a large role in management's selection of loans, as covenants dictate how borrowers behave financially.
In times of economic uncertainty, senior bank loan funds can be hit hard, such as in 2008.
But they can also present risks in a good economic environment. If a borrower's credit improves, the borrower is likely to refinance at better terms, and early payoff is detrimental to the loan portfolio.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Travis Flenniken, CFA, is vice president of investments with DeMoss Capital - demosscapital.com. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by e-mailing him at firstname.lastname@example.org.