Generating Returns from C&I Loans

By Randy Cameron and David Wood

The Paycheck Protection Program created an artificial—if critically necessary—bulge in banks’ commercial loan books. However, even after more than $730 billion in PPP loans in 2020 and 2021, total bank commercial and industrial loans have declined. In fact, as of May 24, $279 billion of PPP loans has been forgiven. Soon, the remaining balance of these loans will be forgiven or scheduled to be repaid over time.

In addition, since the global recession of 2008, the speed of industry consolidation has accelerated, with a marked decline in the number of small community banks and a redistribution of assets to larger and larger banks—affecting both the banks and their communities.

Community banks have weathered the storm through a combination of technology, new methods of delivery, adapting to changes in consumer behavior, and complying with new banking laws. Pure organic growth has also helped. But they have found an additional strategy that is proving quite beneficial.

We are continually analyzing the outcomes of consolidation. How does it affect our banking clients? How can we help them compete? What are the consequences of a shrinking small community bank market within rural communities?

An investment case for senior loans

Today, banks are flush with cash. Given a continuing dovish monetary policy, it’s likely banks will need to be strategic in finding places to deploy their deposits. Do they want to invest in long-term fixed rate loans or securities? Not necessarily. All things being equal, banks would like to book quality loans.

So, where can banks find safe landings for credit related products? Sitting on historic amounts of cash and earning as little as zero to 10 basis points are difficult when the industry’s cost of funds generally exceeds this return by a fair margin. If a bank wants to grow, where will growth come from? Do you adjust rate and risk standards, limits, and product mix? We believe an answer lies within the syndicated loan market for secured C&I loans. It’s a core capital market, a well-established asset class, it’s active, and it’s growing.

Before a community or small regional bank makes the leap, however there are questions the bank must answer. Among them: Is your growth and asset mix, particularly loans types and concentration, consistent with your investment policy? And are there investment opportunities in your market and are they available within your footprint?

Senior loans defined

In general, these borrowers are national or large regional companies and the loans are sizeable—taking the form of nationally syndicated loans that help finance large transactions, like corporate acquisitions and mergers you see in the financial press. The market is brisk. In fact, the first quarter of 2021 saw record volume in this category.

Large borrowers have some inherent advantages over a smaller borrower, including operations spanning multiple economic regions, large customer bases, deep supply chains, access to multiple public and private capital markets and staying power in tough times.

The loans are generally originated by the largest banks in the country. The origination process involves a sponsor, or borrower, who initiates the transaction with an agent bank. That bank structures and negotiates the transaction—ultimately setting pricing and timing—and then gathers a syndicate of other banks and institutions to complete the transaction. The institutions that acquire large portions of the transaction include larger commercial banks, asset managers and other institutional investors.

Typically the loans are all floating rate, with spreads over an index—historically Libor, although this rate is in the process of being phased out. The loans terms are generally five to seven years, and they amortize in whole or part and generally have strong, proven cash flows and attractive interest coverage ratios. Although many borrowers are leveraged at levels higher than their investment grade counterparts, the debt typically is secured by a first lien on all assets.

Firms like Voya work directly with the agent banks to consolidate all of the borrowers’ data such as agent information memoranda, and third-party industry, borrower and economic data. Voya analysts re-underwrite the transactions to bank-like standards for their client banks. The institutions that acquire these loans also analyze and re-underwrite them to their own standards—meaning any given transaction has many analysts going through the structure. Also, rating agencies review and rate these transactions. Regulators review the transactions during the Shared National Credits exams.

The result? It’s rare to see a poorly structured or managed transaction, but there is a clear spectrum of low to higher risk within the industry. Within this spectrum, there is a clear and large “bank-appropriate” volume of loans within the entire market. While the rare “black swan” event happens, even then, when examining how these transactions weathered the past 15 months relative to a regional middle-market portfolio, this market remains a good place to have C&I exposure.

The other benefit? Once the primary transaction has closed, these loans trade in a very active and deep secondary market—banks can acquire the loan from one of the syndicating banks or an institution can divest a loan that it previous acquired. In other words, there is always a liquidity outlet.

To be fair, if it is a loan that is stressed, that sale price will be a market price, not par. But if a bank employs best practices and looks to divest a loan at an early sign of stress, there is a good chance it can sell near par and avoid that potential problem. Compare that scenario to a loan the bank has acquired from another bank and now wants to sell. Just about the only option is to sell the loan back to the original bank, which may or may not want it.

The benefit to the banks

Historically, these loans perform well and have favorable returns, particularly in this low-rate market. When you consider these loans in terms of risk-adjusted returns, a syndicated portfolio compares well to a typical local C&I small market portfolio.

Secondly, it is an available avenue for loan growth. Traditionally, this asset class was the domain of the large money center banks and they kept it to themselves. These banks, driven by volume and efficiency, would invite other banks who could take large, efficient positions in these loans and help the transaction to complete its syndication smoothly. That’s changing.

Rather than receiving the low returns on Treasuries or mortgage-backed securities, why not consider near investment grade loans to supplement or become a cornerstone of your commercial loan portfolio? The relative value and efficiencies of this portfolio, combined with liquidity and flexibility that banks simply do not have with a local C&I portfolio, make these products something that community banks should consider.

Randy Cameron and David Wood are co-managers of the Bank Advisory Group at Voya Investment Management.