Institutional investors have increased their exposure to senior bank loans over the past six months, and will continue to do so, according to interviews conducted by ING Investment Management (INGIM) with 84 pension funds around the world this year.
These findings agree with IPE’s latest Focus Group survey of 22 European pension funds and fiduciary managers, with average assets of €8.8bn.
Senior bank loans are extended to non-investment grade companies and traded in a private secondary market; are generally secured by a borrower’s assets; and first in priority in receiving payments when a borrower is servicing its debts. Investors have favoured them over recent months as yields have been comparable to those available from high-yield bonds for a position higher in the borrower’s capital structure.
Four of the respondents to IPE said that they already invested in syndicated loans and five reported exposure to direct lending. One more is considering syndicated loans and five more are thinking about direct lending.
More findings from this survey on alternative credit investments will appear in the May 2014 issue of IPE.
Another attractive feature of senior bank loans in today’s low-interest rate environment is the fact that payments are generally set at Libor plus a spread, with an average rate-reset period of about 60 days.
INGIM said that this makes the income earned from a senior loan portfolio generally very responsive to changes in short-term interest rates.
This is reflected in the INGIM survey findings. Asked what is the most attractive benefit of senior bank loans, the highest proportion (29%) of respondents cited their diversification benefit within fixed income portfolios.
The paper’s risk-adjusted returns were cited by 19%, low default risk by 14%, and protection against rising interest rates by 10%.
When asked what the main benefit of investing in senior bank loans is, 29% of pension funds said diversification of a fixed income portfolio, followed by 19% who said attractive risk adjusted returns.
One in seven said it was because the default risk is low.
“Senior bank loans offer an excellent balance of income and security, and these characteristics have fuelled strong demand for this asset class over the last couple of years,” said Dan Norman, group head of INGIM’s senior bank loans team.
However, IPE’s Focus Group survey also revealed that investors were evenly split about whether or not they were confident that the asset management industry could provide suitable syndicated loan products in sufficient size for pension funds. They also expressed deep scepticism that their consultants would be able to assess managers’ competence in the asset class.
The respondents saw direct lending as an even bigger challenge on these fronts.
Furthermore, not everyone is persuaded that loans are good protection against rising interest rates.
“It seems to me in the current interest rate environment the Federal Reserve and many investors believe Libor is likely to stay low for an extended time period, and long-term rates are expected to rise much more,” said Phillip Schaeffer, senior portfolio manager at Scott’s Cove Management, a US long/short credit manager with a specialism in high-yield. “The interest rate protection you think you have will not occur until Libor starts going up.”
Moreover, Schaeffer noted many loans have a LIBOR floor set at 1% or more, meaning the coupon would not increase until Libor passes that level.
“A Libor floor would further lengthen the time period before which the coupon on a leveraged loan increases,” he said. “A lot of people do not appreciate the risks they are taking that long-term rates increase before Libor increases.”
INGIM’s survey found that 42% of pension funds believe their peers’ exposure had increased recently, against just 2% that thought it had fallen. Over the next 12 months, 40% of the interviewees expect institutional investors to increase their loans exposure against 8% who expect it to fall “slightly”