Exploring opportunities in senior bank loans

January 30, 2025 with Sébastien Rhéaume

Sébastien Rhéaume, Managing Director at AlphaFixe Capital Inc., introduces us to an asset class that is well-established in the United States but less well-known in Canada: senior bank loans. He discusses their benefits and potential. Additionally, he explains how they can help diversify an investment portfolio and offer partial protection against inflation.

listen via:

Read the transcription

Martin Lefebvre

Hi everyone, I'm Martin Lefebvre, Chief Investment Officer at National Bank Investments. Welcome and thank you for tuning into this NBI podcast. Today our discussion will be on fixed income and more specifically on senior bank loans. And to give us the lay of the land, I'm joined by Sébastien Rhéaume of AlphaFixe Capital.

Bonjour Sébastien. Before we start, maybe just give us a brief description of what this more specific asset class means for investors.

Sébastien Rhéaume

It's an asset class that we don't hear very often in Canada, bank loans. Basically, because when we look at the Canadian market, the six big banks in Canada tend to be very present in the market. If I step back, what is a bank loan? A bank loan is just a company that has a project, needs capital to execute that project and goes to the bank. And most of the times, like I said, in Canada, the bank itself or with the other banks will be able to provide that capital.

When we look at the U.S. market where we have much, much bigger companies and probably a bit more fragmented banking sectors, usually the banks within themselves are not capable of providing all the capital for these transactions, in which case they open up to outside investors. That's where we have a chance to come in and participate. And again, just to put things very clear, we are buying exactly the same structure as the banks have. If the banks, whatever guarantees or protection that the banks have as they lend to the company, we will also benefit. And that's something that's quite unique in capital markets to be able to be sitting exactly where the banks are on the capital structure in terms of all the protections. And again, that's probably one of the biggest features of this asset class is again, being able to benefit from all the protections that the banks make sure that they have from themselves.

Martin Lefebvre

And how does the return or the expected return compare to other fixed income or more traditional assets or even high yield debt or emerging market debt?

Sébastien Rhéaume

One other characteristic of this asset class is that it's a floating rate product, which means that the companies, when they actually raise capital, they commit to pay a spread on top of the overnight rate. Let's say we have a BB-rated company that comes to the market for whatever project they're working on, they need to raise a billion dollars of capital. The banks will lend that money.

And the company commits to pay a spread. In this case, let's say the spread is 300 basis points. It's 300 basis points plus whatever the overnight rate is. If the overnight rate right now is at 4%, so you add 3 % more than that, so you get a 7 % coupon. The beauty also is that if the overnight rate goes higher, which is what we've seen since the pandemic, so every time that the overnight rate goes up, you actually get paid a little bit more. And if the overnight rate goes from 4% to 4.5%, your coupon is going to go from 7% to 7.5%. That's also a very interesting feature of this asset class because it will be able to provide you with some decent returns in the context of rising rates, which is the opposite of usually what happens in fixed income. When rates go up, they tend to actually have negative returns, especially what we saw in 2022. That's another important feature of this asset class.

Martin Lefebvre

You mentioned the banking sector, but are there many industries that go through senior bank loans and what type of diversification are investors looking for when they add this asset class into their portfolio?

Sébastien Rhéaume

When we invest in bank loans, they're mostly U.S.-based companies, and which gives us another feature is that by having access to the U.S. company, you get a much better diversification. The Canadian economy tends to be fairly concentrated in certain sectors. U.S. economy much, much broadly diversified. Think about the healthcare sector. In Canada, it's a public sector. In U.S., it's private sector. You actually have opportunities to invest in the healthcare sector. You can invest in services. There's many, many different areas that you can invest that you don't have access into the Canadian market. The companies that we do invest in are U.S. based. We always hedge for the currency, so there's no currency risk. But you also benefit from getting a much more diversified economy versus the Canadian one, which tends to be bit more concentrated.

Martin Lefebvre

Maybe one last question on investment strategy. You know, most of our retail clients or most retail clients are invested in more traditional or plain vanilla, fixed income and stock market. So how do senior bank loans fit within a broader investment portfolio?

Sébastien Rhéaume

The reason we like bank loans given where we are in the cycle is a bit what I was explaining. First of all, because it's a floating rate product, you actually get protection for higher rates. I mentioned before, in 2022, fixed income in Canada had negative returns to the order of 11% to 12%, depending on where you were. And what happens if you think about it, 2022 was a very difficult year for capital markets in general.

And when that happens, usually you expect your fixed income to protect you. If the stock market goes down, your fixed income protects you. Fixed income did not play that role in 2022. And again, it's not because something went massively wrong. It's just because as interest rates rise in 2022, interest rates rose anywhere between 150 to 200 basis points. You have a duration of seven. It's just pure math. The beauty of adding this asset class to your portfolio is that you're kind of hedging yourself against a more inflationary environment. And the reason I say that is because if we are in a more inflationary environment, the central banks will be tending to raise rates. As they raise rates, that usually has a higher impact in terms of overall rates, which is negative for usually fixed income. But in this case, because you're being paid a spread on top of the overnight rate, as the central banks raise rates, you actually get paid more.

So how do we integrate this into a portfolio? The way we would look at this is that when you look at your allocation to fixed income, and let's say your allocation is 50% of your entire portfolio. So that 50 % is there to protect against some rough environments on the equity side or some negative returns on the equity side. We have a very strong conviction that inflation will be a lot more volatile and also that interest rates in general will be much higher than they were in the last 10 to 15 years. So, 50% is your fixed income. Within that 50%, I think it's very legitimate to say: “I still want some duration”, because inherently if rates go down, I want to have some protection. But I do want to protect myself for higher rates. You could easily say: “I'll take half of that allocation, and I'll put it into a bank loan strategy – again, floating rate note protects me - and then I have the other half which is going to be there to if interest rates go down. Then I'll be able to capitalize on that.”

And again, at 30,000 feet, we're aiming for 225 basis points more than the overnight rate. That's kind of our strategy. This is a strong conviction that we have. We do think that we are in a higher interest rate environment. If you think that your overnight rate is going to be anywhere between 3% to 4 % throughout the cycle, which is kind where we are right now, and you add another 225 basis points on that, or 2.25%, then you get some returns that are 5.25%, 6.25%, which makes this a very compelling asset class in itself. And if you have the other part of your fixed income in the more traditional part of the fixed income, I think that combining those two gives you a very optimal portfolio.

Martin Lefebvre

Sébastien, thank you very much for your participation. I think you've put out very clearly the potential benefits senior bank loans may have in the current environment, especially with central bankers talking about pausing for this time around and inflationary pressure coming from the Trump administration. Thank you very much for tuning into this NBI podcast. And for everyone listening, thank you and we'll talk again next month.

Sébastien Rhéaume

Thank you.

host

Martin Lefebvre

Chief Investment Officer and Strategist, National Bank Investments

Martin Lefebvre

Martin is the Chief Investment Officer of National Bank Investments responsible for the development investment soclutions and the management of tactical asset allocation mandates. With over 20 years of experience in financial markets, Martin also managed the portfolio management team at Private Banking 1859.

guest

Sébastien Rhéaume

Managing Director, AlphaFixe Capital Inc.

As one of the founding partners of AlphaFixe Capital, Sébastien is responsible of portfolio management and strategy development. Working in the investment industry since 1991, he specializes in Canadian fixed income. Before founding AlphaFixe Capital, he served as Vice President, Corporate Bonds, at Addenda Capital. In addition, he worked at CDP Capital Communications as Director, Telecommunication investments, after working in the areas of mergers and acquisitions and audit. CPA and CFA charterholder, Sébastien has a degree in Public Accountancy from McGill University where he also completed his Bachelor of Commerce.

The data and the information supplied in the present document, including those supplied by third parties, are considered accurate at the time of their printing and were obtained from sources which we considered reliable. We reserve the right to modify them without advance notice. This data and this information are supplied as informative content only. No representation or guarantee, explicit or implicit, is made as for the exactness, the quality and the complete character of this data and this information. The opinions expressed are not to be construed as solicitation or offer to buy or sell shares mentioned herein and should not be considered as recommendations.

Views expressed regarding a particular company, security, industry, market sector, future events (such as market and economic conditions), company or security performance, upcoming product offerings or other projections are the views of only the portfolio managers, as of the time expressed and do not necessarily represent the views of National Bank of Canada and its subsidiaries (the “Bank”). Any such views are subject to change at any time based upon markets and other conditions, which could cause actual results to differ materially from what the portfolio managers presently anticipate(s) or project(s). The Bank disclaims any responsibility to update such views. These views are not a recommendation to buy or sell and may not be relied on as investment advice.

® NATIONAL BANK INVESTMENTS is a registered trademark of National Bank of Canada, used under licence by National Bank Investments Inc.

National Bank Investments is a signatory of the United Nations-supported Principles for Responsible Investment, a member of Canada’s Responsible Investment Association, and a founding participant in the Climate Engagement Canada initiative.