Don’t Bank on Bank Loans in 2023

04 May 2023

4 min read

Matthew Sheridan, CFA| Lead Portfolio Manager—Income Strategies

AJ Rivers, CFA, FRM, CAIA| Head—US Retail Fixed Income Business Development

As bond yields rose in 2022, investors sought refuge in high-yield bank loans, whose floating coupons are often heralded as an antidote to rising rates. But with conditions shaping up differently in 2023, bank loans may face challenges. We think income-seeking investors should instead consider a more diversified approach that balances rate and credit risks. Here’s why.

Bank Loans Are Vulnerable When the Credit Cycle Turns

Floating-rate bank loans tend to do well when conditions are just right: the Federal Reserve is raising rates and the economy is growing. But such conditions typically don’t last long. In fact, we think the tide may soon turn: the banking crisis is tightening financial conditions, the Fed’s May rate hike may be its last, and US GDP growth is poised to slow in the second half of the year.

Exposure to bank loans at this late stage of the credit cycle is risky. Bank loans have historically underperformed during economic downturns (Display).

Bank Loans Have Underperformed During Recessions

Rolling 12-Month Total Return: January 2002–April 2023

Bank-loan returns dipped into negative territory during the last two recessions, meaningfully underperforming Treasuries.

Historical and current analyses do not guarantee future results.
US high-yield bonds are represented by the Bloomberg US Corporate High Yield Index, US Treasuries are represented by the Bloomberg US Treasury 10–Year Bellwether and US bank loans are represented by the Credit Suisse Leveraged Loan Index.
Through April 30, 2023
Source: Bloomberg, Credit Suisse, National Bureau of Economic Research and Alliance Bernstein (AB)

That’s partly because of the exaggerated cyclical effect of investors rushing into the market when rates begin to climb and rushing out when rates begin to fall. But it’s also because bank loans can carry meaningful credit risk. And that seems to be especially true today.

For one thing, as bank-loan coupons floated higher in 2022, the businesses that issued the bank loans saw their cost of capital ratcheting up, creating financial strain. In other words, the borrowing companies took on the interest-rate risk that investors sought to avoid.

Issuers should have at least partly hedged this interest-rate exposure with interest-rate swaps, but many did not. As a result, our analysis suggests that the average B3-rated bank-loan issuer is likely to experience negative free cash flow in 2023 because of underfunded floating-rate debt liabilities. According to S&P, roughly half of B-rated loans today are at risk of credit distress and downgrade.

But that’s not all. Because bank loans tend to be a cheaper financing option for weak credits, the high-yield bank-loan market comprises more lower-rated debt than the high-yield bond market to begin with. Indeed, since 2009, bank-loan credit quality has deteriorated, while high-yield bond quality has improved (Display).

Bank Loans’ Share of Lower-Rated Debt Has Risen over Time

Credit Rating as Share of Market

Historical and current analyses do not guarantee future results.
Ratings for bank loans are as a percent of par value; ratings for bonds are as a percent of market value.
*Does not show unrated loans or loans rated above BB
Through January 31, 2023
Source: Barclays, Bloomberg, Pitchbook, S&P and AB

Thus, as the US economy heads into a low-growth phase, bank loans are at greater risk of default than high-yield bonds. Further, the share of the high-yield bond market that is secured—31% as of December 31, 2022—is relatively high, which may translate into higher recovery rates for high-yield bonds in the event of default.

Three Reasons to Strike a Better Balance

The way we see it, investors should consider ditching bank loans in favor of a balanced approach to income investing. Among the most effective active strategies are those that pair government bonds and other high-quality, interest-rate–sensitive assets with growth-oriented credit assets in a single, dynamically managed portfolio.

This barbell approach can help investors get a handle on the interplay between rate and credit risks and make better decisions about which way to lean at a given moment. The ability to rebalance negatively correlated assets helps generate income and potential return while limiting the scope of drawdowns when risk assets sell off.

In today’s environment, lifting a barbell strategy provides three key benefits:

1) Income generation. Yields across risk assets are higher today than they’ve been in years, giving income-seeking investors a long-awaited opportunity to fill their tanks. Investors should aim to diversify not only globally but also by sector. Sectors such as high-yield corporates, emerging-market debt and securitized assets—including commercial mortgage-backed securities and credit risk-transfer securities—can also serve as a buffer against inflation by providing a bigger current income stream. In our view, investors should favor higher-quality credit, be selective and pay attention to liquidity. Lower-rated credits in any sector are most vulnerable in an economic downturn.

2) Duration. While high-yield bank loans typically have little to no duration—a measure of sensitivity to changes in interest-rate levels—government bonds can be an excellent source of duration. And we think a moderate amount of duration from high-quality government debt could be an especially good thing in portfolios today. As inflation ebbs and the economy slows, duration tends to perform well, acting as an offset to the volatility of growth assets.

3) Negative correlations. In 2022, equity and fixed-income markets broke with convention and fell in tandem, leaving almost nowhere for investors to hide. Some market observers wondered whether the days of negative correlations between US Treasuries and risk assets were behind us. But recent market events have proved that thesis wrong. As risk assets sold off in March, US Treasuries enjoyed a strong rally, reestablishing the negative correlation between the asset classes in a risk-off environment. We expect this restored relationship to persist.

Take Care as the Cycle Turns

As the credit cycle enters its twilight stage, income-seeking investors should carefully weigh their options. In our view, a barbell strategy that balances rate and credit risks may succeed where bank loans will not. Above all, we think this is an ill-advised time to bank on bank loans. As the tide advances, investors may just find that floating-rate bank loans are castles in the sand.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams and are subject to change over time.

About the Authors

Matthew Sheridan, CFA

Matthew Sheridan is a Senior Vice President and Portfolio Manager at AB, primarily focusing on the Income Strategies portfolios. He is a member of the Global Fixed Income, Global High Income and Emerging Market Debt portfolio-management teams. Additionally, Sheridan is a member of the Rates and Currency Research Review team and the Emerging Market Debt Research Review team. He joined AB in 1998 and previously worked in the firm’s Structured Asset Securities Group. Sheridan holds a BS in finance from Syracuse University. He is a CFA charterholder. Location: New York

AJ Rivers, CFA, FRM, CAIA

AJ Rivers is a Senior Vice President and Head of US Retail Fixed Income Business Development. Prior to joining AB in 2022, he was the director of Product Strategy at Lord Abbett. Throughout his career, Rivers has been directly involved in the rates and credit markets, and has directed the product development and competitive positioning of investment strategies in traditional and alternative assets. He has held roles in trading, risk management, portfolio analytics and product strategy. Rivers attended the McDonough School of Business at Georgetown University and graduated from the University at Buffalo for undergrad. He is a CFA charterholder, a Financial Risk Manager (FRM) and a Chartered Alternative Investment Analyst (CAIA). Location: Nashville

This is a marketing communication. This information is provided by AllianceBernstein Schweiz AG, Zürich, a company registered in Switzerland under company number CHE-306.220.501. AllianceBernstein Schweiz AG is a financial service provider within the meaning of the Financial Services Act (FinSA) which is not subject to any prudential supervision in Switzerland. Further information on the company, its services and products, in accordance with Art. 8 FinSA can be found on the Important Disclosures page at www.alliancebernstein.com. It is provided for informational purposes only and does not constitute investment advice or an invitation to purchase any security or other investment nor is it a recommendation to subscribe to a financial service. The views and opinions expressed are based on our internal forecasts and should not be relied upon as an indication of future market performance. The value of an investment can go down as well as up and investors may not get back the full amount they invested. Capital is at risk. Past performance does not guarantee future results.

This information is directed at Qualified Investors only and is not intended for public use.

Don’t Bank on Bank Loans in 2023

Bank Loans Are Vulnerable When the Credit Cycle Turns

Three Reasons to Strike a Better Balance

Take Care as the Cycle Turns

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