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By Sumit Desai, CFA | 10-02-2015 09:00 AM

Near-Term Hurdles for Bank-Loan Funds

They still have a place in portfolios, but investors need to be aware of some technical factors.

Sumit Desai: The bank-loan category grew significantly over the past few years, peaking at almost $147 billion in net assets in March 2014. However, sentiment toward bank loans has changed since then, and the category has lost almost $26 billion via outflows in the last 12 months. It should be noted, however, that the majority of outflows were concentrated, as more than half of the redemptions came from five funds out of 55 total.

Despite these outflows, though, the overall bank-loan category has performed relatively well in the past year. While not a perfect comparison, we view bank loans as similar to high-yield bonds in that they're both generally issued by highly leveraged companies. During the past twelve months ended Sept. 30, 2015, the bank-loan Morningstar Category squeaked out a positive 0.2% return, while the high-yield bond category has actually declined 3.6%. Credit markets sold off significantly during the past year, due mainly to the energy and commodities sectors. However, these hard-hit sectors represent only 6% of the bank-loan market versus almost 20% for high-yield bonds.

We do think that bank-loan funds have a place in investors' portfolios, but they need to be aware of some technical factors that can create near-term challenges. The first issue is around Libor floors. Most loans issued over the past few years include Libor floors that require rates to go up fairly significantly before the interest income investors receive is adjusted upward.

We also have some concerns around liquidity for bank loans. We've seen recent examples in which bank-loan funds either needed or chose to tap into credit lines in order to meet their heavy redemptions in a timely manner, mainly due to extraordinarily long settlement times.

However, for investors willing to take on these challenges, Morningstar covers several actively managed bank-loan funds. Across the nine bank-loan funds in Morningstar's coverage universe, five funds have a Morningstar Analyst Rating of Bronze, while the remaining funds are rated Neutral. Across our Bronze-rated funds, we'd highlight Eaton Vance Floating Rate (EABLX), RidgeWorth Seix Floating Rate High Income (SFRAX), and Fidelity Floating Rate High Income (FFRHX) as funds worth considering for their experienced management teams and relatively cautious approaches to investing in bank loans.

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