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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.

In a rising-rate environment, bank loans tend to outperform fixed-rate securities. Of course, investors en masse are aware of this, which is why retail asset flows for the sector increase during these periods. What is not as well understood is that, in a flat-rate environment, bank loans also outperform the broad bond benchmark. The main reason for the outperformance is the yield advantage that the bank loans provide over the Barclays index. In today's market, the Barclays index has a current yield to maturity of only 1.6%, which gives the bank-loan index a 4.2% yield advantage. If we stay in the current flat-yield environment, bank loans look very attractive.

Perhaps the largest risk to bank loans is the potential for a U.S. recession in the near future. While this is not expected by the majority of surveyed economists, the impending fiscal cliff could push the United States into a recession if Congress doesn't come to a compromise on future tax rates. A recession would increase defaults for the bank-loan sector, which would depress the prices of loans. However, we wouldn't see this as a reason to panic. Morningstar has been tracking the bank-loan sector since 1989, and the available data shows that bank loans typically have positive performance even during recessions. The only year that bank loans posted a negative return in this time frame was 2008, when they lost 29%.

Much of that loss was due to the overissuance of new loans in the wake of the leveraged buyout boom of 2006 and 2007. Many companies used the bank-loan market as their preferred source of financing, especially those engaged in leveraged buyouts. By their nature LBO companies have large amounts of debt, and when Lehman Brothers went bankrupt, fear spread throughout the market, pushing loan values down to historic levels. To make matters worse, many buyers of bank loans were highly leveraged themselves and had to dump loans on the market to meet margin calls. In the panic, bank loans became very illiquid and all new issuance stopped.

The market has learned its lesson from the financial crisis because current bank loans are being issued with a conservative risk profile that is more typical of the period before 2006. The highly leveraged hedge fund investors who drove much of the market volatility have not returned in large numbers. While a recession will hurt returns, the bank-loan market appears better prepared today and may even post positive returns in the next recession if history is any guide.

ETF Investment Option
The  PowerShares Senior Loan Portfolio BKLN is the only ETF that invests in bank loans. It tracks the S&P/LSTA U.S. Leveraged Loan 100 Index, which is a market-value-weighted index designed to track the 100 largest bank loans. The index's focus on the largest loans will increase liquidity of the portfolio. Because the bank-loan market can become illiquid, the ETF has special liquidity provisions. First, because of the unique nature of bank loans and the specialized trading desk required to transact loans, BKLN will take creations and redemptions in cash instead of the traditional in-kind method. This means that the fund is responsible for buying and selling loans in the fund. Also, the fund may borrow through an existing credit line in response to adverse market conditions. Borrowings are limited to 33 1/3% of the fund's total assets. If BKLN uses this provision, the fund will become leveraged similar to a closed-end fund. In the event of a market panic, the portfolio manager has the ability to choose between using the credit line or selling individual loans. This increased flexibility should improve overall liquidity of the ETF.

Other Alternatives
In the mutual fund space, the two highest-rated funds are  Eaton Vance Floating Rate EIBLX and  Fidelity Advisor Floating Rate High Income FFRAX. For investors interested in higher yields and added leverage,  ING Prime Rate PPR and  Eaton Vance Floating-Rate Income EFT could make sense in the closed-end market. I would caution investors that PPR and EFT both currently trade at a premium to their net asset values and are currently leveraged over 30%.

Timothy Strauts is an ETF analyst at Morningstar

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