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Are Bank-Loan Funds Ready to be Loved Again?

Right now, bank loans look more attractive than high-yield bonds.

Timothy Strauts, 10/15/2012

Investors have been craving fixed-income funds with attractive yields over the past few years. Just last year alone, high-yield bond funds attracted $51 billion in new assets and emerging-markets bond funds gained $20 billion. Despite this continuing yield-fest, one area of the market that is not receiving much attention is bank-loan funds. Last year they attracted only $1.3 billion in new assets.

Most investors typically become interested in bank loans when interest rates are expected to rise. With the Federal Reserve committed to maintaining low rates for the next several years, current investor apathy to bank loans shouldn't come as a surprise. But with yields in the high-yield bond sector near historic lows, bank-loan funds are looking more and more attractive on a relative basis.

What Are Bank Loans? 
Senior floating-rate bank loans are variable-rate, senior secured debt instruments issued by non-investment-grade companies. Bank loans have a variable rate that adjusts every 30 to 90 days. The duration of a bank-loan fund is near zero because of the regular adjustment of interest rates. This rate is a fixed-percentage spread over a floating base rate--typically the London Interbank Offered Rate, or Libor. Bank loans are the most senior security in the capital structure because they are secured by collateral such as equipment, real estate, or accounts receivable. Bank loans are considered safer than traditional high-yield bonds because the secured collateral protects the investor in a default.

Investment Case
The iBoxx $ Liquid High Yield Corporate Bond Index has a current yield to maturity of 6.18%. For comparison, the S&P/LSTA U.S. Leveraged Loan 100 Index, which tracks the 100 most-liquid bank loans, has a yield to maturity of 5.81%. For only a 0.37% drop in yield you get a portfolio of bank loans, which are much safer investments than traditional fixed-rate high-yield bonds. Bank loans have a lower average default rate of only 3% compared with high yield's average default rate of 4.75%. Because all bank loans are senior secured bonds, in the event of a default they have a high average recovery rate of 65%. Traditional high yield is dominated by senior unsecured bonds, which have a recovery rate of only 44%. If defaults rise, bank loans would be the better choice of the two for more-conservative investors.

Most investors' portfolios are dominated by fixed-rate bonds. The biggest risk fixed-rate securities face is the potential for rising interest rates. An easy way to minimize this risk is to diversify a bond portfolio with floating-rate securities. While few expect rates to rise dramatically in the near term, it pays to be prepared. If you wait for rates to rise before protecting yourself, it may be too late when the time comes.

The table below illustrates how the diversification benefits of bank loans can help the fixed-income sleeve of your portfolio. Bank loans have negative correlation to Treasuries and a minimal correlation to the other fixed-income sectors. The low correlations are due to the floating interest rate and the fact that the bonds are below investment grade. Similar to high yield, bank loans are most correlated to the equity market.

Timothy Strauts is an ETF analyst at Morningstar

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