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By Christine Benz | 08-21-2013 02:00 PM

Bank Loans Possible High-Yield Substitutes, but Watch Risks

Although defaults are decreasing and fund inflows are increasing, bank loans carry significant credit risk and illiquidity compared with other fixed-income vehicles.

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Christine Benz: Hi. I’m Christine Benz for Morningstar.com. Investors have been gravitating to bank-loan funds because of their lack of interest-rate sensitivity, but the funds still have plenty of risks. I recently sat down with [Morningstar's] Tim Strauts and Sarah Bush, both bank loan-fund analysts, to discuss some of the pros and cons of the bank-loan fund category.

Let’s discuss the pros and cons of bank-loan investments. Sarah, one of the things that investors have really been attracted to recently is the idea that they'll have some imperviousness to interest-rate hikes down the line. Let's talk about how that works, and why that is widely viewed as one of the big attractions of these investments.

Sarah Bush: It’s really understandable that with people being concerned about rising interest rates and seeing what we saw earlier in the spring and early summer, that bank loans will be interesting to investors. Bank loans basically reset to a spread over LIBOR periodically. There's almost no interest-rate risk in these portfolios. That’s something I think is very attractive to investors. However, it is one thing to remember that these are adjusting over short-term rates, and short-term rates have been relatively low and are expected to stay pretty low for a while. If you see the [10-year Treasury rate] move up, you’re not going to see an immediate jump in yield on your bank-loan fund.

Benz: In this recent jump up with interest rates in sort of that May/June period, how did bank loans perform?

Bush: They did pretty well. There were a little bit of losses within the category, but nothing like what you were seeing in other types of fixed-income asset classes.

Benz: One of the big risks of bank-loan funds, which we’ll get to later, is their credit sensitivity. But, Tim, you noted in a recent article that actually default rates in the bank-loan space have improved quite a bit recently. Let's talk about that.

Tim Strauts: Because the economy has been doing pretty well. Everyone talks about the economy; we’d all love to have 3%-4% gross domestic product growth rates. But we don't need that in bank loans to be successful. We just need positive, slowly improving growth, and that’s kind of what we have seen. The latest default numbers are looking in the low 1.0%-1.5% range. Historically, they've typically averaged around 3.0%. We’re at about half of the default levels we’ve seen historically. That’s just due to the improving economy we’re seeing.

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