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.
So, when flows come out quickly, fund flows run out of these funds, the managers can be forced to sell into a down market, and that's something that happened in 2008. Some of these funds were down--I think the median for the category was a 30% loss. Now, the funds did bounce back very well the following year, but if you didn't stay through that volatility, you wouldn't have seen the rebound.
Benz: So, Sarah, I want to talk about what I should be looking at, when I'm looking at a bank loan portfolio. So I want to have my eyes on, "How liquid is it? How would I know that? And also how junky is it?"
How can I go about discerning that when I'm looking at a portfolio?
Bush: Well, there are a couple of things. First of all, one thing to be aware of is that these funds do come in different flavors. So there are the exchange-traded closed-end funds for which liquidity is going to be a little less of an issue, because they are not dealing with those flows, in and out.
There is an intermediate type of fund that are continuously offered, but they only offer monthly or quarterly redemptions.
And then there is the true open-end type of fund. With that open-end type of fund, you're going to expect to see some other assets in there--cash or high-yield or investment-grade bonds to provide a little bit of added liquidity.
Benz: So, the manager knows that he or she has to meet those redemptions on a daily basis, so needs to keep a portion of the portfolio liquid.
Bush: Right. And this is something that all the managers are aware of, but it's certainly something to pay attention to.
In terms of credit quality, you're going to see that these funds, because they are leveraged loans that they're investing in, they are concentrated and in BB and B rated debt.
I think a warning sign would be if you saw a lot of below B rated debt. So now you're talking CCC issuers and those can have very high default rates over time. That's something to be aware of if you look at a fund with a very high yield. You'd want to make sure that that's not coming, because they are taking on tons of credit risk.
Another thing I think you'd want to see is a fairly well diversified portfolio. I don't think this is an asset class where it makes a lot of sense to build up large positions in a fund.
And then to the extent that you can to gauge, you want a manager hopefully who has at least been in this asset class long time or with a particular fund over a long period, and has substantial credit resources available to him. So ... you want to see a large analyst staff.
Benz: That makes sense. And there are lots of newbies in this category; so you need to be careful.
Benz: Sarah, I want to talk about what kind of role such a fund should play in a portfolio? Clearly, given the risks that you've just outlined, it's not a money market alternative. How should I think about a bank loan fund as part of a broadly diversified portfolio?
Bush: I really think this is way to diversify the fixed-income component of your portfolio. I think a helpful way for people who are not as familiar with bank loan funds is to think of this as more like a high-yield fund. So it can provide a little bit of extra yield, but you don't want this to take up a huge portion of your portfolio. And I think that point about it not being a money market fund is very important, because I think a long time ago people started to think of these as money market funds, and given the performance of 2008 and 2009, it's very clear that they are not.
Benz: So, are you concerned about the flood of assets that we have seen going into this group, that perhaps people have unrealistic expectations?
Bush: I think as long as people are comfortable with the credit risk, I think that's a very important part of thinking about these funds. The other thing is, I think anyone who would look at the 2009 and 2010 timeframe, where the returns in this category were just extraordinary, that's not what you're going to see most likely going forward. A lot of the loans that were really beaten up in 2008 are trading a lot closer to par now.
Another thing that's kind of interesting about this asset class is that the loans can be called by the borrowers if they are doing particularly well. So, there really isn't a lot of upside if a loan trading at a 100 and 101, it can be called at 100. It's really not going to be something that you're going to see a big gain in. So, I think you really need to be aware of that when you're thinking about these funds.
Benz: So finally, I wanted to touch on what you think are the standouts within this category. I know Fidelity is one that you like a lot. Let's talk about what you think is going well there?
Bush: Sure. I think the Fidelity Floating Rate Fund is a very good fund. It's got a manager who has been doing this for a long time and really has access to a lot of the research resources that I talked about earlier. They work with high-yield bond group at Fidelity, and I think that it's really been a standout. Another thing that I really like about this fund is that it is conservatively positioned and actually lost a lot less than its average peer in 2008. I think that's what you want out of a fund like this.
Benz: And that's a daily redemption fund.
Bush: That is – it's actually the first true no-load option in the category.
Benz: And then Eaton Vance is another one you like.
Bush: Eaton Vance is another one we like.
Benz: They have several.
Bush: They have several. It's a floating rate fund, which is kind of their more pure bank loan fund, and that's a fund that I like. The manager has been there a long time, been through some cycles, not very aggressive.
The other thing just to keep in mind, too, is that some of the funds in this category have leverage, which can be something that will boost your yield, but it's something that can hurt you on the downside, and these are both funds that are not levered.
Benz: Thanks, Sarah, so much for sharing your insights. We appreciate it.
Bush: No problem. I am glad to be here. Thanks, Christine.
Benz: Thanks for watching, I am Christine Benz for Morningstar.com.