Strategy Spotlight

Understanding Bank Loans

Here we explain the fundamentals of syndicated bank loans and why they may be attractive to investors looking to reduce interest rate risk and diversify a fixed income portfolio.

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Sabeen Firozali, Credit Strategist:A syndicated bank loan is a commercial loan to a corporation made by a bank. The company’s assets serve as collateral for the loan, so the loan is considered secured debt of the company. The bank holds on to a piece of the loan and sells of the rest of it to other parties. The buyers of the pieces of that loan then become lenders to the borrowing company.

Bank loans are important because loan coupons are tied to interest rates like LIBOR or prime.

Text on screen: Why Invest in Bank Loans

  • Floating interest rate
  • Senior in capital structure
  • Credit agreements

    Because they are floating rate instruments, they can be a good way to reduce interest rate risk. They’re also senior in priority of payments in case of a default or a bankruptcy. Bank loan agreements contain certain protections that help safeguard the lender’s collateral.

    Syndicated bank loans also come with risks. Without debt cushions underneath the loans, loan recoveries in default scenarios could be lower than what you would expect. 

    Text on screen: Potential Risks of Investing in Bank Loans

  • Reduced subordination
  • Weakening covenants
  • Reinvestment risks

    Protections offered to lenders under credit agreements have also been waning lately. Lastly, borrowers of bank loans can pay back loans with minimal penalties, which result in reinvestment risk for lenders.

    Text on screen: How does a syndicated bank loan work?

    Capital Structure

  • Bank Loans
  • Unsecured Debt
  • Equity

Since bank loans are secured debt of the company, they sit on top of a company’s capital structure and have first priority in payment in case of a default.

Graphic: The graphic titled The Capital Structure Waterfall: Realized Losses has a big green box titles assets to the left, with an arrow at the bottom that says losses. The arrow is pointing to the right column which includes three boxes: Equity, Unsecured bonds and Secured loans.

That is, cash from assets goes to pay loans first, then unsecured bonds, and then to the equity holders. The implication of that waterfall is that secured loans are the last to absorb losses when they do occur.

Because loans are the first to receive payment and last to realize losses, they have historically recovered at higher rates than high yield bonds have.

Chart: This bar chart show recoveries from high yield - 40% range, and bank loans - 70%-80% range.

Loan recoveries historically have been in the 70% to 80% range, while bond recoveries have been in the 40% range.

A covenant is a condition that is stipulated in a credit agreement between the borrower and the lender.

Affirmative covenants are things that a borrower must do, so things like a borrower must report financial statements after a certain amount of time, or a borrower must pay taxes.

Negative covenants are things that a borrower cannot do. Examples are a borrower cannot do M&A in excess of a certain amount without getting consent from the lender, or a borrower cannot pay a dividend to a shareholder without getting consent from a lender.

Financial maintenance covenants are those that require a borrower to meet certain financial metrics at certain time periods, such as, a borrower must meet a debt to EBITDA level of 4.0 by the end of this year.

Compared to the last cycle, however, bank loans now offer reduced subordination and weaker covenants. For that reason, it is crucial to scrutinize loan agreements to ensure that adequate protections are being offered.

It is also essential to assess the capital structure of the borrower to make sure that there is adequate subordinated debt and equity to absorb first losses. 

In conclusion, bank loans are a good way to diversify a fixed income portfolio and have exposure to floating rate credit risk that sits on top of a company’s capital structure.

Call-to-action: For more insights and information, visit pimco.com

Disclosure


All investments contain risk and may lose value. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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