Loans vs bonds
Voya IM manages the NN Flex Senior Loan Fund, a Luxembourg-based Sicav fund distributed by Netherlands-based NN Investment Partners.
Bakalar explained that senior loans are different from bonds in several aspects. Unlike bonds, they are secured by a first priority lien on a borrower’s assets – usually receivables, inventories or fixed assets.
Also unlike most bonds, loans carry a floating interest rate tied to Libor. This results in a near-zero duration risk and an opposite price reaction to interest rate movements than that of bonds, according to Bakalar.
Loan funds tend to perform better than bond funds when interest rates rise. Floating interest rates eliminate the duration risk, he said.
Loan coupons tend to be lower than that of high-yield bonds. But high prices for bonds during what has recently been effectively an issuer’s market, reduce bond yields below that of loans, he said.
Loans deliver return around 4.9% while the yield on high-yield bonds has been in the vicinity of 4.75%, according to Bakalar.
In terms of scale and diversity of issuers, the loan market is similar to that of high-yield bonds. Globally, it amounts to more than $1tr, with US borrowers accounting for around 90% of it. The fund’s benchmark, the S&P/LSTA Leveraged Loan Index, includes more than 1000 issuers.
Loans are also actively traded, with the number of dealer desks, trading volumes and spreads similar to that of high-yield bonds. The average bid/ask spread for a large senior syndicated loan is between 35 and 50 basis points, according to Bakalar, which is lower than for a bond.
What makes buying and selling a loan different from that of bond is the settlement process. The transaction involves four parties: the buyer, the seller, the originating bank and the borrower. All of them must consent to the deal before it is executed, and usual settlement period is 10-12 days.
“The borrower has to consent because we control their collateral,” said Bakalar. In case of default and bankruptcy proceedings, loan holders usually become equity holders. If a loan buyer has a record of hostile takeovers of companies, the borrower can decide not to go through with the transaction.
More rigorous analysis
The flex fund holds $5.4bn in assets, in 376 loans, spanning 37 industries, as per the fund’s February 2017 monthly report. Almost 86% of the loans are from US companies, the remainder coming from Canada and Europe. The electronics and healthcare sectors have the highest share of the portfolio, each at approximately 12%.
Management of a loan fund is more involved than that of a bond fund, according to Bakalar. Rigorous credit analysis is necessary since most issuers are below investment grade, usually B or BB, and the probability of default is higher. In addition, “we have to analyse the value and the sufficiency of the collateral,” he said. “Bondholders don’t have to worry about it.”
The flex fund, launched in 2009, is more conservative than its peers, according to Bakalar. It only invests in loans without augmenting returns with high-yield bonds or derivatives, at the cost of increased risk. While the ratio of non-performing loans in the market is just above 1%, he said the fund’s ratio is ten times lower.
Voya’s management team consists of 28 investment professionals and 30 back office and support staff. “Loans are an intensive asset class to administer,” said Bakalar.
Investment decisions are made by an investment committee, co-headed by Bakalar and Dan Norman, group head. It consists also of a chief credit officer and five senior portfolio managers.
The loans in the portfolio are priced daily. Voya uses two pricing providers, who gather and aggregate buy/sell indications from dealers.
Loan risk
Owning loans presents three layers of risk: insolvency of companies, supply/demand imbalance and flight to quality. The risk of insolvency is familiar, relatively well understood and managed within the investment process.
Bakalar explained that the supply/demand imbalance risk causes aggressive pricing conditions affecting loans in a similar way as they affect bonds. In a “risk-off” environment, loans would also likely suffer as they are fundamentally a risk asset.
In Asia, the fund is available for professional investors in Hong Kong and Singapore. Bakalar estimated that 30% of the fund’s assets come from Asia, and the balance from Europe.
