Beyond the madding crowd: Bank loans in a diversified portfolio

We are often asked for a view about bank loans, in particular how we would fit them into our asset allocation framework.  This paper is an attempt to answer those questions and to help decide whether and how to integrate loans into our forecasting and Model Asset Allocation processes.  As an asset class of similar size to high yield (HY), that sits somewhere between cash and HY in terms of risk versus reward and with projected returns of 7%-8% over the next 12 months in Europe and the US (our view), we conclude that bank loans merit addition to our Model Asset Allocation.  We intend to have incorporated the asset class by end-2023.  

Main conclusions: 

• The market capitalisation of the bank loan asset class is now roughly equivalent to that of high yield credit in both the US and Europe.
• The bank loan asset class occupies a place in the risk-reward space somewhere between cash and HY.  Its income flows come from variable interest rates (like cash) but are subject to defaults (like HY).
• Over time, it has generated higher returns than cash but with more volatility and has underperformed during recessions, with no systematic link between that relative return and central bank interest rate cycles.
• It has underperformed high yield over time but has tended to outperform during recessions, with no tendency to outperform when central banks tighten (though they underperform when central banks ease).
• US loans have generated negative total returns in only three years since 1992 (four since 1998 in Europe).
• History suggests current yield on bank loans is of limited use as a guide to future returns.  Comparing current yield to cash rates improves predictive power but the best tool we tested was the discount margin.
• Current yields are high, compared to their histories, but current yield spreads and discount margins are closer to historical norms.  This gives no reason to expect extreme returns over the next 12 months.
• We expect a global slowdown but not synchronised global recession and expect default (recovery) rates to normalise rather than rise (fall) sharply (the best environments are likely to be economic recovery/expansion).
• We forecast 12-month bank loan total returns in the US and Europe of 7.5% and 7.7%, respectively (as of 28 April 2023).  This is higher than we expect on cash (and maybe HY).  Even if default and recovery rates were to hit Global Financial Crisis levels, we estimate that total returns would still be in the 2%-3% range.