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THE REVIVAL OF THE BANK LOAN MARKET

03/06/2013

As markets start wondering about the timing of QE tapering and simultaneously banks need to deleverage, we believe qualified investors should take a closer look at bank loans.

It is fair to say that Central Bankers have been driving markets up so far this year with extended and massive QE policies.
One of the consequences of QE is the artificially low rate environment (both short term and long term). Even if we anticipate this “landscape” to be maintained in the near future, any sensible investor has to prepare for - for at least a part of his investments- for QE policy exit as inevitable subsequent rising yields will impact fixed income portfolios (even if we think the bigger risk lies in the speed of the rise more than in its extent).
There are some attractive instruments to protect against this risk though, one of them being investment in bank loans, also called “leveraged loans” or “senior loans”.
Bank loans are, like bonds, obligations to pay the holder interest and principal. Most of the time, the borrowers are corporates that are leveraged (and if rated, in the High Yield territory). They are privately traded though.

A series of features makes the asset class an attractive and “rare beast” in the current environment:

1/ Their coupons are floating, typically based on LIBOR rates. That means Libor constitutes a floor, and returns can increase with rising yields. That also implies a low volatility for the asset class.
2/Probability of default is lower than for HY bonds. Additionally, they are senior to high yield bonds in the capital structure and secured against identified assets. Which offers higher recovery in case of default.
3/ The market is expanding as banks are under increasing capital constraints on their credit books: that encourages them to sell their sub-investment grade exposure to the market, even if of good quality. The market is therefore offering more & more diversification and constitutes an additional investment universe to the High Yield one. In Q1/2013 issuance volume has been the largest of the last 6 years.

As there is no such thing as a free lunch, the relatively limited size of this market is definitely a mitigating factor to keep in mind as market liquidity can be impacted pretty quickly.

Finally, as of now, the usual investors in the asset class of the likes of CLOs are not that active anymore. That is especially the case in Europe, which is not as developed as the US on that market. That is positive as it puts newcomers and banks (which are more conservative than the average investor and account for 60% of new deal allocations in Europe) in a comfortable position: they can require more conservative structures and higher margins on new deals than in the US (where banks account for 10% of new issues’ subscribers).

We think the investment case is appealing: in the “credit universe”, bank loans offer the same yield as High Yield, together with hedge against rising rates and better protection.  Buy & Hold strategy.

 

OUR VIEWS

- This is an expert market: invest through funds

- That also preserves liquidity

- Prefer Europe to the US

Global Strategist Societe Generale Private Banking
Global Head of Fixed Income Société Générale Private Banking