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By Christine Benz | 04-28-2011 11:51 AM

A Bank-Loan Fund Buyer's Guide

How to assess the risks and decide if a bank-loan fund is right for you, and what to look for when choosing one.

Christine Benz: Hi. I'm Christine Benz for Morningstar.

Investors have been sending torrents of cash into the bank loan category, and the category now has about $60 billion in assets.

Here to discuss what you should know before buying a bank loan fund is Sarah Bush. She is a senior mutual fund analyst for Morningstar.

Sarah, thanks so much for being here.

Sarah Bush: Thank you for having me. It's good to be here.

Benz: So, you've been specializing in this category, Sarah, and I'd like to talk about what has been the big attraction for investors with these funds recently?

Bush: Right, and as you mentioned there has just been a huge amount of flows into this category, and I don't think it's very surprising that they've seen this kind of interest, given that people are so concerned about rising interest rates. So, what's in these funds typically are floating rate leveraged bank loans, and that floating rate piece is very important for understanding why people are interested in these funds.

Typically, the underlying loans reset every 90 days at a spread over LIBOR. So, that means that, first of all, you're relatively insulated against increases in interest rates. You're not going to see a lot of principal fluctuation because of those changes. And then as interest rates goes up, assuming they do go up, you're going to see your fund's yield improve a lot with interest rates.

Benz: So, investors like that, seeming imperviousness to rate rises, but let's talk about some of the risk factors, things that people should know about how things can go the other way and work against them.

Bush: Absolutely. And I think one thing that's very helpful is to look at how these funds did during 2008 and 2009. As I mentioned, these loans are leveraged bank loans, and the leverage reflects the fact that the companies that are issuing the loans, or the borrowers, are highly leveraged companies. So, there are loans that came out of LBOs, they are used to finance M&A activity, and we typically like to think of them as floating rate high-yield. So, really the kinds of credit risks that you see in these funds is in-line with what you would see with a high-yield bond fund. So, that's something to be very careful and very aware of.

Benz: So, you alluded to the 2008-period performance, and the magnitude of losses was really shocking in some of these funds.

Bush: It was, and I think the second risk to think about, which I think was even more of an issue in 2008, was the lack of liquidity that you can see in these loan funds when the credit markets turns south. This is a relatively small corner of the market, bank loans take a long time to settle. And as a result, when credit markets sour, it can be difficult for the managers to sell these loans.

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