TaxProfessionals.com
Posted by Tiffany Gaskin

Investing in Loans

Investing in Loans

For investors looking for income, these are interesting times. Fixed-income assets yields are at some of the lowest levels ever recorded. Meanwhile, the average inflation rate has been 4.2% in the last 12 months. This combination of low rates and relatively high inflation means that the "real yield" (minus the inflation rate) for many fixed-income investments is below zero. For those looking for higher returns and protection against inflation and who understand that there is no reward without some risk, this may be a good time to learn more about investing in leveraged loans.


What are leveraged loans?

Leveraged loans are loans made by banks or other financial institutions to companies that often use them to refinance their debt, finance mergers and acquisitions, or finance projects. Companies that receive these loans often have credit ratings below the investment grade. These loans usually last for 5 to 7 years, although the borrower can repay them at any time. These are backed by collateral, such as the borrower's real estate and equipment and intellectual property, including trademarks, brands, and customer lists.

Unlike bonds that pay fixed interest, bank loans pay interest at regularly adjustable rates, based on a short-term interest rate available to the public. One of the most commonly used rates for setting interest rates on leverage is the London interbank offered rate. Known as LIBOR, this is the rate at which banks borrow unsecured funds from other banks in the wholesale money market in London. LIBOR is adjusted periodically, usually every 30-90 days, although individual loan rates do not always move as much as LIBOR itself.


Loans as Investments

When banks made leveraged loans, they were added to the bank's balance sheet in the past. Over time, banks began to form unions in which various banks could jointly lend to a borrower and offer loans for sale to investors, such as insurance companies, pension funds, mutual funds, and ETFs. Since 2010, the value of outstanding leverage has increased from $500 billion to about $1.2 trillion in 2021, almost as much as the $1.5 trillion high-yield bond market dollars. The growth of the lending market has attracted larger and more established borrowers, who could otherwise have raised capital by selling bonds.

It is believed that the bottom line for the loan market is positive. Most issuers have managed to refinance short maturities, reduce financing costs and increase liquidity. These shares have lowered the default rate and reduced the number of stressed names in the market. Assuming the current positive momentum, the market should be well-positioned to meet its debts and other obligations.


Why invest in loans?

Leverage lending offers potential protection against inflation and hedging against rising interest rates that inevitably accompany inflation. Bond prices usually fall as interest rates rise. Higher inflation almost always leads to higher rates, as rate hikes are the preferred way for central banks to manage inflation. However, unlike most bonds, interest rates on leverage are adjusting upwards, along with increases in key consumer interest rates. This means that loans are less likely to lose value than most fixed-income investments when inflation and interest rates rise. While past performance is no guarantee of future performance, leveraged loans have historically outperformed longer-term fixed-income securities in an environment of rising interest rates.

Another advantage of loans is that they generally offer relatively high returns. Like high-yield bonds, there are promises of repayment from borrowers who are not investors, and their creditors expect greater compensation for taking that risk. Loans can also help diversify portfolios. Due to their relatively low-interest rate sensitivity and attractive income levels, leverage has historically been positively correlated to inflation and Treasuries. Diversification and asset allocation do not guarantee profits or guarantees against losses.


Risks of Investing in Loans

While loans can offer better protection against inflation and rising interest rates than bonds, savvy investors know that there is no "free lunch." This means that no investment is without risk. Since the leveraged loan is usually granted to companies with lower credit ratings, they pose a significant risk that the borrower will ultimately not be able to pay the interest and principal. However, this credit risk can be somewhat offset by the fact that creditors are among the first to be paid if a borrower goes bankrupt before the majority of bondholders or shareholders.

Although mutual funds that have loans can be attractive to investors seeking income and capital preservation, it is important to note that, like bond funds and money market funds, they are not backed by banks or the Federal Deposit Insurance Corporation (FDIC) and should not be considered cash alternatives or cash equivalents.

Also, unlike bonds, loans are non-registered bonds and are traded over the counter rather than in an exchange. This can mean that the credit market sometimes goes through periods where the number of buyers and sellers becomes imbalanced and fair value trading becomes difficult.


How to Invest

While most investors in the loan market are large institutions, professionally managed mutual funds or exchange-traded funds can help you add leveraged exposure to your portfolio. The funds provide access to an asset class normally reserved for institutional investors and overnight liquidity and diversification across borrowers and sectors.


Summary

  • Historically, leveraged loans have been tied to inflation but not to the US Treasury.

  • Leveraged loans currently offer higher yields than most fixed income assets, which are at record highs.

  • Leveraged loans introduce credit and liquidity risk in exchange for higher yields and inflation protection.

  • Leveraged loans may be worth considering additions to fixed income portfolios, especially when inflation and interest rates rise.


FOR MORE INFORMATION ON HOW TIFFANY GASKIN CAN BEST HELP YOU WITH YOUR TAX FILING NEEDS, PLEASE CLICK THE BLUE TAB ON THIS PAGE.


THANKS FOR VISITING.

Tiffany Gaskin
Contact Member