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Investing Specialists

Bank Loans Appealing but Far From a Cash Alternative

These funds are best used to augment--rather than supplant--high-quality fixed-income exposure.

Investors have demonstrated ample enthusiasm for the bank-loan category during the past year. More than $25 billion in new assets has flown into the category during this time, the fourth-largest take of any category in Morningstar's database. Those new inflows represent more than one fourth of the total assets in the category.

What's Not to Like?
Given the current fixed-income environment, you don't have to squint too hard to see what investors have found attractive about these funds. For starters, their robust yields are compelling, particularly given the anemic payouts from competing investments. The median bank-loan fund has an SEC yield of about 4%, nearly twice as high as the median intermediate-term bond fund's SEC yield.

Bank loans' unique properties make them attractive for the interest-rate environment that could lie ahead, too. Bank-loan funds are composed of slices of loans made by banks, and the interest rates on these loans reset every 90 days, at an amount over LIBOR. Because their interest rates effectively reset to keep pace with the prevailing-yield environment, bank-loan funds aren't vulnerable like other bond funds when interest rates trend higher; shareholders actually benefit. In rising-rate years such as 1994 and 1999, bank-loan funds gained an average of 7% and 6%, respectively.

By contrast, the typical intermediate-term offering lost more than 4% and 1.3% in those two years. For conventional bond funds, the availability of newly issued bonds with higher rates make the older, lower-yielding bonds in their portfolios less attractive; bank-loan funds don't face the same problems. Marta Norton, an investment manager with Morningstar Investment Services, also argued in this video that bank loans are decent hedges against inflation; after all, it stands to reason that in periods when inflation is headed up, so are interest rates, and those higher rates flow through to bank-loan shareholders.

Of course, a weak economic environment is the Achilles' heel of bank loans because businesses can struggle and defaults can increase. However, many U.S. companies have been building cash and fortifying their balance sheets in the wake of the credit crisis. Floating-rate loans are also higher in the capital structure than high-yield bonds, leaving their owners in a better position if defaults do indeed pick up.

A Long Way From Cash or Even High-Quality Bonds
All the same, there's a risk that investors are overestimating bank loans' defensive properties. Yes, they'll likely hold up better than most bond types in a rising-interest-rate environment; they even have a very good shot at delivering positive returns under such a scenario. And because current yields are higher than those of most other bond types, you get paid reasonably well in the meantime.

At the same time, it's a mistake to be lulled into a false sense of security about the asset class. After all, bank loans with floating rates are often issued to companies with less-than-perfect credit pictures; many such firms also operate in cyclical industries. In market shocks and flights to quality characterized by worries about the economy's strength, bank loans can and will suffer. In the three-month period from September through November 2008, the typical bank-loan fund lost one fourth of its value amid the financial crisis and forced selling by hedge fund managers who needed to raise cash to pay off departing shareholders.

That was a worst-case scenario, but other market shocks aren't out of the question. During the worst of the eurozone crisis in August 2011, for example, the average bank-loan fund lost 4.4%, even as the typical intermediate-term fund actually gained money during that same period. The average standard deviation--a measure of volatility--for bank-loan funds has been more than twice as high as has been the case for intermediate-term bond funds during the past five years, and it dwarfs the volatility level of the average short-term bond fund.

That's not to say you shouldn't make room in your portfolio for bank loans at all; there's a lot to like about the asset class, particularly given what could lie ahead for fixed-income investors. It does indicate, however, that bank loans make sense as part of the "aggressive kicker" component of your portfolio rather than to meet short- or even intermediate-term liquidity needs. So if you're adding to bank loans, do so because your portfolio is light on credit-sensitive exposure (such as high-yield or multisector bond funds).

It's also worth noting that the category includes a broad gradation of risk levels, with some offerings placing a higher premium on the credit quality and liquidity of their holdings than others. That means that investors in bank-loan funds should thoroughly understand a fund's strategy, including its risk controls, before buying in. The year 2008 also serves a valuable test case if your aim is to get your arms around a bank-loan fund's appetite for risky assets.

A version of the article appeared Dec. 14, 2012.

See More Articles by Christine Benz