Charles Schwab issued the following announcement on Jan. 10.

Bank loan prices fell sharply in the fourth quarter of 2018, after delivering strong returns through the first three quarters of the year.

Risks remain elevated in the bank loan market, and we see potential for prices to fall further.

With the Federal Reserve likely to slow its pace of rate hikes going forward, bank loan coupon rates are unlikely to reset much higher.

Bank loan investors should proceed with caution in 2019. Bank loan prices fell sharply at the end of last year but have since rebounded in the first few days of the new year. The risk of further price declines remains elevated, however. Most importantly, bank loans should always be considered aggressive investments and should be in line with investors’ risk tolerance parameters.

The basics of bank loans

Bank loans—also called leveraged loans or senior loans—are a type of corporate debt with a few key characteristics:

Sub-investment-grade credit ratings. Bank loans tend to have sub-investment-grade credit ratings, also called “junk” or “high-yield” ratings. Junk ratings are those rated BB+ or below by Standard and Poor’s or Ba1 or below by Moody’s Investors Services. A sub-investment-grade rating means that the issuer generally has a greater risk of default, so bank loans should always be considered aggressive investments.

Floating coupon rates. Bank loan coupon rates are usually based off a short-term reference rate plus a spread. The short-term reference rate is usually the three-month London Interbank Offered Rate, or LIBOR, although that will likely change in the future as LIBOR is set to be retired in a few years. The spread above LIBOR is meant as compensation for bank loan investors. Because bank loans come with increased risk—keep in mind that they’re junk rated—investors demand higher yields in case the issuer cannot make timely interest or principal payments.

Secured by the issuer’s assets. Bank loans are secured, or collateralized, by the issuer’s assets, such as inventory, plant, property and/or equipment. They are senior in a firm’s capital structure, meaning they rank above an issuer’s traditional unsecured bonds. But don’t confuse “senior and secured” with “safe.” Bank loans still can, and do, default like traditional corporate bonds.

Prices plunged in the fourth quarter of 2018

After enjoying nearly two years of relatively stable prices, bank loan prices got hit hard in the fourth quarter of last year. After hovering around $98 or $99 for most of 2018, the average price of the S&P/LSTA Leveraged Loan 100 Index plunged to $93.27 by the end of 2018, a nearly 6% decline in less than three months. Prices rebounded sharply at the start of this year, however.

Bank loan prices fell sharply during the last few weeks of 2018

Bank loan prices, as reflected by the S&P/LSTA Leveraged Loan 100 Index, dropped to $93.2 in December 2018, after hovering around $98 or $99 for most of 2018 Prices have rebounded in early 2019.

Source: Bloomberg, using daily data as of 1/7/2019. Past performance is no indication of future results.

Prior to the plunge, bank loans were the best-performing bond investment of the year.¹ Through the first nine months of the year, the index posted a total return of 4%, but the drop over the final few weeks of the year pulled the index into the red for the year—the 2018 total return for the S&P/LSTA Leveraged Loan 100 Index was -0.6%.

After a strong start to 2018, bank loan returns ended up in negative territory by the end of the year

Bank loan total return, as reflected by the S&P/LSTA Leveraged Loan 100 Index, dropped to negative 0.6% in December after peaking above 4% in October 2018.

Source: Bloomberg, using daily data as of 12/31/2018. S&P/LSTA Leveraged Loan 100 Index. Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.

Risks remain elevated

Despite the rebound through the first few days of 2019, we see plenty of risks ahead. We see the potential for prices to remain under pressure this year and beyond, and the floating coupon rates offer less of a benefit if the Federal Reserve slows down the pace of its rate hikes.

Deteriorating credit quality is our primary concern. Leverage is a measure of an issuer’s debt relative to its earnings, and leverage for many bank loan issuers is at high levels. With corporate profit growth expected to slow this year, growing debt loads could be more difficult to manage. And we’re not the only ones concerned about the rise in leverage—the growing chorus of those concerned includes former Fed Chair Janet Yellen, the International Monetary Fund, and the Office of the Comptroller of the Currency.

Covenant quality also remains weak. A bond covenant is a set of terms, defined in the bond’s prospectus, which outlines what the issuing firm can or can’t do with regard to its business. Moody’s Investors Services tracks loan covenants, and its “Covenant Quality Indicator” remains at its weakest level.2 Without strict covenants, firms can engage in riskier business practices, like taking on more debt or even selling profitable parts of the business (for a one-time gain), essentially removing a stable provider of cash flows that can be used to repay its debts.

Deteriorating covenants can have a negative impact when we begin to see a rise in corporate defaults. Since the absence of covenants allows firms to engage in more risky business activities, there may be less value in a given company if it were to default, leading to lower recovery rates. (Recovery is what a bondholder ultimately receives from holding a defaulted bond or loan.)

Bank loans are relatively illiquid. Rather than trading on the over-the-counter market like most corporate bonds, bank loans often need to be physically delivered (by faxing the paperwork, for example) to the buyer. This makes them harder to sell, and can lead to price declines during periods of market volatility. And given the more private nature of bank loans, individual investors can generally only access the market through mutual funds or exchange-traded funds. After relatively stable inflows for most of 2018, the almost $5 billion outflow in November was likely one of the reasons why prices fell so sharply to end the year. If more investor angst leads to more outflows, prices may fall even further.

November saw almost $5 billion in net outflows for bank loan mutual funds and ETFs

Net outflows from bank loan mutual funds and ETFs were almost $5 billion in November, following 10 consecutive months of net inflows.

Source: Morningstar Inc. Columns represent monthly net flows into mutual funds and ETFS categorized by Morningstar Inc. as "Bank Loan" from November 2016 through November 2018.

Coupon rates might not rise much higher. The floating coupon rates that bank loans offer are less attractive now that the Federal Reserve is likely nearing the end of its rate-hike cycle. Although projections from the Federal Open Market Committee still point to two rate hikes in 2019, the market is not as optimistic. According to Bloomberg implied probabilities, there’s a greater chance of a rate cut than a rate hike this year.3 Investors may be better positioned by locking in yields that intermediate-term bonds offer, rather than waiting for floating-rate coupons to catch up.

What to do now

Understand the risks in the bank loan market and make sure any investment in bank loans matches your risk tolerance. An allocation to bank loans may still be appropriate for investors with a more aggressive risk tolerance, but we would not suggest adding to positions today.

Despite their “senior and secured” status, they carry junk ratings, have elevated default risk, and can suffer bouts of heightened volatility. We do think prices may fall further in 2019—while coupon rates might not reset much higher—so investors should proceed with caution.

Original source: https://www.schwab.com/resource-center/insights/content/bank-loans-proceed-with-caution