Since the Global Financial Crisis, the acceptance of syndicated bank loans (“bank loans”) by institutional and retail investors has increased significantly, due to 1) their higher yield relative to other public credit alternatives, and 2) their floating rate coupon that would increase with increasing interest rates. As a result of their increased investor acceptance, there has been a proliferation of bank loan issuance and the composition of the market has evolved meaningfully from what it was before the Global Financial Crisis. This includes trends such as covenant-lite loans, bank loan-only capital structures, increased leverage multiples, and changes to the industry allocation of the asset class. These changes have attracted the scrutiny of U.S. Senators, former Federal Reserve Chairmen, as well as investors themselves who have called into question the deterioration in quality of leveraged loans and whether they pose significantly more risk now than in prior periods.
We have investigated these issues, as we believe investors should think critically about the relevance of the historical performance characteristics of the asset class given these recent trends and whether it will be as resilient during an economic downturn. We believe these changes could lead to higher default rates, lower recovery rates, and thus lower total returns when the next credit downturn occurs. Importantly though, we do not think there are systemic issues in the bank loan market that would cause us to recommend eliminating the exposure for our clients. We believe that discerning bank loan managers should be able to capitalize on some of the changes in the bank loan market and the uncertainty they may bring.