Beyond the madding crowd: bank loans in a diversified portfolio

Invesco flexible approach for navigating market uncertainty paul jackson

Read the latest paper from Paul Jackson, our Global Head of Asset Allocation Research. He shares in-depth analysis on bank loans, before delving into the role the asset class can play in investor portfolios.

It has been a while since I used the Beyond the Madding Crowd label, inspired by Victorian English writer Thomas Hardy. It denotes a deep dive into a particular topic, rather than getting lost in day-to-day market noise. The subject matter this time is bank loans – an asset class that I am often asked about, but which has not featured in mine and András Vig’s asset allocation framework to date.

In this piece, I aim to answer some of those “frequently asked questions”, as well as looking at the role bank loans could play in our asset allocation framework* and your portfolios going forwards.

*This is a theoretical portfolio and is for illustrative purposes only. It represents our views and does not represent an actual portfolio. Nor is it a recommendation of any investment or trading strategy.

For those who are short on time, I summarise my main conclusions here.

  • The bank loan asset class occupies a place in the risk-reward space somewhere between cash and high yield.
  • Over time, it has generated higher returns than cash but with more volatility. Meanwhile, it has underperformed high yield over time, but has tended to outperform it during recessions. There are nuances to both of these statements, which I look at in further detail in the full paper.
  • US loans have generated negative total returns in only three years since 1992 (four since 1998 in Europe).
  • History suggests the current yield on bank loans is of limited use as a guide to future returns. Comparing current yield to cash rates improves the predictive power, but the best tool our team 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.
  • Our team expects a global slowdown but not a synchronised global recession. We expect default (recovery) rates to normalise rather than rise (fall) sharply. The best environments are likely to be those of economic recovery/expansion.
  • Our team forecasts 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 higher than high yield. 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.

Read the full paper for further insights.

Starter for 10: some background information on the asset class

Bank loans are loans issued by banks to institutions (banks and other entities) that are the most senior, secured debt. They sit at the top of the borrower’s capital structure. In other words, if the debtor company has problems, bank loans have higher priority than bonds, which has historically resulted in higher default recovery rates.

When banks want to reduce their exposure to loans, they can be sold. Loans are often combined, repackaged and sold to investors who receive interest payments and principal repayment in return.

Most leveraged loan indices only include loans that are rated below investment grade. They are called leveraged loans due to their frequent use in the financing of leveraged buyouts.

These terms are typically used interchangeably to refer to the asset class. The “senior” or “senior-secured” label refers to the fact that the asset class sits at the top of the borrower’s capital structure.

Bank loans are secured on the assets of the borrower, but are usually non-investment grade. This makes for a natural comparison with the high yield credit segment of the fixed income universe. This explains why they offer a high rate of interest.

The big difference between high yield bonds and bank loans is that the latter usually offer a floating rate linked to a benchmark such as LIBOR (London Interbank Offered Rate) or SOFR (Secured Overnight Financing Rate). 

Bank loans have an advantage over bonds when interest rates rise, as they are typically “floating rate” assets. In other words, the income flows adjust upward rather than remaining fixed. For this reason, it is often said that bank loans have near-zero duration, despite having multi-year maturities.

As introduced previously, bank loans sit at the top of the borrower’s capital structure. If the debtor company has problems, bank loans have higher priority than bonds, which has historically resulted in higher default recovery rates.

In both the US and Europe, the bank loans market appears to be roughly the same size as the respective high yield market:

  • The market capitalisation of loans included in the Credit Suisse Leveraged Loan Index was US$1.4trn on 31 March 2023 (source: Credit Suisse), compared to $1.3trn for the Bloomberg US Corporate High Yield Index (source: Bloomberg).
  • In Europe, the Credit Suisse Western Europe Leveraged Loan Index had a market capitalisation of €0.4trn on 31 March 2023, the same as that of the Bloomberg Pan-European High Yield Index. 

Given its characteristics, the bank loan asset class occupies a place in the risk-reward space somewhere between cash and high yield. Its income flows come from variable interest rates (like cash), but the loans are usually non-investment grade.

Our analysis, outlined in detail in the above paper, suggests that the best environments for bank loans are the recovery after recession (when spreads are likely to be wide) and a prolonged economic upswing that brings rising central bank rates but low defaults.

Each quarter, András Vig and I publish an in-depth view of our model asset allocation, outlining which asset classes we favour and why. This is called The Big Picture.

Model portfolios consist of a diversified group of assets. They are designed to achieve an expected return with the corresponding risk. Model portfolios are usually extensively researched and, in most cases, have a combination of managed investments.

Given its size and characteristics, we intend to incorporate the bank loan asset class into our model asset allocation framework by the end of 2023.

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Important information

  • Data is provided as at 30 June 2023, sourced from Invesco unless otherwise stated.

    This is marketing material and not financial advice. It is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. Views and opinions are based on current market conditions and are subject to change.