Bank Loans

Bank Loans are one of the oldest and most fundamental financial arrangements in the world. At its heart, a bank loan is a simple contract: a financial institution (the lender) provides a sum of money to a borrower (an individual or a company), who agrees to repay that money, plus an extra charge called interest, over a predetermined period. For individuals, this might be a mortgage for a new home or a loan for a car. For businesses, loans are the lifeblood of commerce, used to fund new projects, manage day-to-day operations, or acquire other companies. From an investor’s standpoint, the world of bank loans offers a unique asset class. While you're not lending money directly from your own pocket, you can invest in funds that hold a portfolio of corporate bank loans, turning this traditional debt instrument into a potential source of income and stability for your portfolio.

Think of a bank loan as a structured IOU with a few key ingredients that determine its flavor:

• Principal: This is the main course—the actual amount of money borrowed. If a company borrows $10 million to build a new factory, the principal is $10 million.
• Interest Rate: This is the “fee” for borrowing the money, set as an Interest Rate. It can be:
  • Fixed: The rate stays the same for the entire life of the loan, providing predictable payments.
  • Floating: The rate changes periodically, typically tied to a benchmark reference rate like SOFR (Secured Overnight Financing Rate), which has largely replaced the older LIBOR. This means the loan's interest payments will rise and fall with the market.
• Term (or Maturity): This is the repayment timeline, which could be a few years for a business equipment loan or decades for a commercial real estate loan.
• Collateral: This is the safety net for the lender. The borrower often pledges assets (like real estate, inventory, or equipment) as collateral. If the borrower defaults, the lender can seize and sell these assets to recoup its money.

For the average investor, you won't be negotiating loan terms with a Fortune 500 CEO. Instead, you can access this market through specialized funds. Here’s why a value-oriented investor might find them appealing.

Investing in bank loans can be a savvy move, especially in certain economic climates. The main attractions boil down to a “belt-and-suspenders” approach to safety and income.

• A Hedge Against Rising Interest Rates: This is the star feature. Most bank loans available to investors have floating rates. When central banks raise interest rates to combat inflation, the interest payments on these loans also increase. This means your income from the investment goes up. This is the exact opposite of what happens to traditional bonds, whose fixed payments become less attractive (and their price falls) when new bonds are issued at higher rates.
• First in Line for Repayment: In the world of corporate finance, there’s a pecking order for who gets paid if a company goes belly-up. Bank loans are typically Senior Debt. This means in a bankruptcy, the loan holders are at the front of the line to get their money back, ahead of bondholders and certainly ahead of stockholders (who are last). This “senior” status, often combined with being secured by collateral, provides a powerful margin of safety.
• Relatively Lower Volatility: Because of their senior status and floating-rate nature, bank loans tend to have more stable prices than stocks or even high-yield bonds. They don't offer the explosive growth potential of stocks, but they can provide a smoother ride.

Directly buying a single corporate bank loan is typically reserved for large institutions. For the rest of us, the most common routes are:

• Bank Loan Mutual Funds: These are professionally managed funds that pool investor money to buy a diversified portfolio of bank loans.
• Bank Loan Exchange-Traded Funds (ETFs): Similar to mutual funds, but they trade like stocks on an exchange, offering more intraday liquidity.

No investment is without risk, and bank loans are no exception. A smart investor always looks at the other side of the coin.

• Credit Risk: This is the big one. It's the risk that the borrower will fail to make payments or default entirely. Many of the loans packaged into funds are made to companies with less-than-perfect credit ratings (i.e., below investment grade). These are often called leveraged loans because the borrowing companies already have a lot of debt. The higher yield they offer is compensation for this higher risk.
• Liquidity Risk: Bank loans are not traded on a public exchange like stocks. They are bought and sold in a private market between institutions. This can create Liquidity Risk. During times of market panic, a fund manager might find it difficult to sell loans quickly without accepting a steep discount, which can hurt the fund's value.
• The Flip Side of Rates: While floating rates are great when interest rates are rising, they work in reverse, too. If rates fall, the income you receive from your bank loan fund will also decrease.