Bank-Loan Funds Aren't a Great Place to Stash Cash

Question: Can I use bank-loan funds as a cash alternative in my portfolio?

Answer: Bank-loan funds have been eye-catching in the current low-yield environment because of their higher yields and potential to hold their ground--or even gain--in a rising-rate scenario. In fact, funds in this category attracted more than $600 million in new money in May 2015, according to Morningstar fund-flows data.

But they're not a slam-dunk, especially for short-term needs or as a cash alternative. Morningstar fund analyst Sumit Desai, who specializes in fixed-income strategies, outlined some of the risks of investing in bank-loan funds during a panel discussion at the Morningstar Investment Conference in Chicago last week. As Desai explained, investors need to be aware of the issues with these types of funds--mainly, credit risk and liquidity risk.

What Are Bank-Loan Funds? Bank-loan funds, or floating-rate funds, invest in secured floating-rate bank loans, taken on by corporations. These loans are typically pegged to Libor, or the London Interbank Offered Rate; this represents the rate at which the major banks can borrow from each other in the London interbank market over short-term periods, ranging from overnight to one year. Because the loans have floating rates that reset every 30-90 days, they have little interest-rate risk, and the yields also have the potential to go higher if rates rise.

In some ways, it's not hard to see why an investor may be tempted use these funds as a place to park cash: Bank-loan tend to have much higher yields than traditional savings accounts and money market mutual funds. Owing largely to those higher payouts, they have earned better total returns over the past three- and five-year periods (4.5% and 5%, respectively) than the ultrashort-bond category, the short-term bond category, or even the intermediate-term category.

Credit Risks Although they take on very little interest-rate risk, bank loans take on credit risk. Bank loans are issued by below-investment-grade companies; in fact, the typical bank-loan fund has a single B credit rating. As such, bank-loan funds are more akin to high-yield bond funds than they are to short-term bond funds that focus on Treasuries or higher-quality corporate debt.

And like funds that invest in high-yield bonds, these funds can have very volatile returns (sometimes correlated to big swings in equity markets). The typical bank-loan fund lost nearly 30% of its value in 2008, for example. A long-term investor with a diversified portfolio was probably not as fazed by this loss; after all, it was then followed by a 40% gain in 2009. But someone who was using bank-loan funds as a place to park short-term assets would have seen one third of their cash wiped out that year.

Liquidity Risks In addition, the funds face liquidity risks; these have been more evident than ever in recent years, when fund flows into and out of the category have been very volatile.

The liquidity issues facing bank loans are twofold, explains Desai. One issue is, if you want to sell a bank-loan position, can you find someone who will want to buy it from you without affecting the price? That's a challenge in the short term, because dealer inventories are low and there's not a lot of trading in the space, Desai said.

The other concern is settlement times for bank loans, which can last anywhere from four days to 60 days. So, that means if a portfolio manager sells all or part of a bank-loan position, he or she may not have the cash in hand for another two or three weeks. That can be very concerning at a time when a fund is experiencing big redemptions, Desai said.

This is exactly what happened in December 2014, when bank-loan funds' performance sagged and nearly $7 billion in investor dollars left the category. Many of the larger bank-loan funds that faced heavy redemptions had to use lines of credit to meet those redemptions.

In fact, recent liquidity concerns led Morningstar analysts to downgrade two medalist funds in the bank-loan category--

How Should Investors Use Bank-Loan Funds? Because of the credit-quality and liquidity risks, investors should consider bank-loan funds as part of their high-yield exposure, preferably as part of a diversified bond portfolio.

Investors need to keep their expectations in check: These funds may not always earn positive returns with attractive yields. Because of their potential for big performance swings (2008 is a case in point), they really aren't the best place to park assets for the short term.

Also, if an investor is hoping to pick up yield as rates rise, these funds may not offer the yield one might expect, especially if the Fed decides to raise rates slowly. As Desai explained, if rates rise, income will go up eventually, but the rates have to rise beyond a Libor floor (which is basically protection for the companies that distribute loans). In many cases, that's 75 to 100 basis points higher than where we are today. So, if Libor rises a little bit--say 25 basis points--you may not get a great income return from a bank-loan fund, Desai said.

More Reading Why Yields on Floating-Rate Bank Loans Aren't Floating (Yet)

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