Can Bank-Loan Funds Shield You From Rising Rates?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Bank-loan funds were extremely popular in 2013, but flows turned the other way in 2014. Joining me to discuss the category is Russ Kinnel--he's director of fund research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Good to be here.

Benz: Russ, you wrote about the bank-loan category in the August issue of Morningstar FundInvestor. You talked about flows going in and out of the category. But before we get into that and maybe talk about some of Morningstar's favorite bank-loan funds, let's talk about what these funds do, for people who aren't familiar with them.

Kinnel: They invest in bank loans, which in some ways are similar to corporate debt. It's debt owed by a company. But because they are bank loans, (1) they don't trade as much, and (2) they have a feature that gives them appeal in today's environment, which is that the interest rate adjusts with changes in Libor. So, if interest rates rise, the yield on these loans will rise, which that means there's less interest-rate risk because the yields will rise, whereas normally in a regular bond, the yield is set at a certain level. So, if interest rates rise, that bond loses appeal.

Benz: Let's discuss flows because I think investors were perhaps attracted to bank-loan funds because of that very feature. They anticipated that rates were going to start to rise, so they flocked to these funds. We saw enormous inflows; more recently, though, we've seen outflows. Is this kind of the classic fear/greed cycle that we've seen with lots of other categories in the past?

Kinnel: I think a little bit. Performance hasn't been so extreme in either direction that you have tremendous reactions. But I think a little bit. For years, we've been talking about rising interest rates, so that's a logical selling point. But it means that bank-loan funds have really become big, whereas they used to be a pretty small piece. If you go back to '08, there was less than $10 billion total AUM in the bank-loan category. Fast-forward to 2013, and it's over $130 billion. That has actually come down a bit, but clearly there's a lot of appeal there. A lot of that is just people wanting to protect their bond portfolios from rising rates.

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Benz: Advisers were probably playing into this as well. They were putting clients in these funds in the expectation that rates would rise and investors would be protected.

Kinnel: That's right. Most of the money is coming in on the load side, meaning advisor-sold funds.

Benz: Let's talk about liquidity in this category. These bank loans aren't always so liquid. In some cases, it's been challenging to manage a portfolio of bank loans in an open-end fund format where you provide that daily liquidity. Let's talk about that issue.

Kinnel: The first bank-loan funds were actually interval funds, where you could only get in or out on a monthly basis. That was their first way of managing that liquidity. Over time, they've all become daily liquidity funds, which means you can get in and out that day. But it is a challenge because they don't trade as much. So, bank-loan managers have to do a number of things to manage that. Often, they have to hold a little more cash than you might in, say, a high-yield bond fund. You might also make a point of having more bonds that are at the more liquid end of bank loans so that if you get redemptions you are prepared. Also, most bank-loan funds have lines of credit so that they can borrow money themselves if they get a lot of redemptions.

Benz: In fact, we saw a few bank-loan funds tapping those lines of credit.

Kinnel: That's right. In 2014, there were three funds that had outflows of $1 billion or more in a single month, which is a lot, obviously. And at least a couple of funds out there actually tapped lines of credit, and we were told it was just for a couple of weeks. I don't have a problem with them tapping their line of credit--that seems like a reasonable thing to do when you get a lot of redemptions. But it shows that the liquidity issues are real. These funds couldn't just simply sell quickly enough to meet redemptions--or at least not sell at a good price.

Benz: We have recently been hearing from a lot of bond-fund managers about concerns regarding liquidity in the bond market. Would bank loans be affected by some sort of a liquidity shock for bonds?

Kinnel: Certainly to a degree. I think we're hearing that liquidity is drying up across the board in the bond world, and liquidity has never been great in bank loans. There are some positives. If you think about a lot of the dire scenarios, they revolve around recessions, and at least a bank loan is senior to, say, a high-yield bond. So, there is some reason to think at least it's higher on the credit-quality scale and, therefore, may be a little more in demand in a recession. But [liquidity issues are] really across the board and are certainly hitting the high-yield and bank-loan areas most heavily.

Benz: So, for investors who are looking at this category and maybe looking at some of the attractions that you outlined, what should they know to ensure that they have a good experience and that they're holding these funds in the right part of their portfolio? What things should they know before they invest here?

Kinnel: You have a small amount of interest-rate risk, but much less than your typical bond fund. So, that's the good thing. The downside is you have some credit risk and you have some liquidity risk, so you want to understand how your fund handles that. You may want one that has a little more in cash to handle that. You might also select a closed-end bank-loan fund because, obviously, they are not going to be affected by redemptions. On the other hand, the closed-end funds have leverage, so in other ways, they are going to give you a little greater credit risk and maybe make the ups and downs more dramatic. So, it's a real trade-off.

Benz: Another thing that you mentioned in your Morningstar FundInvestor article, too, was the fact that even if rates begin to creep up, you're not necessarily going to see that higher yield right out of the box. There will be a delayed effect.

Kinnel: That's right. There is a ceiling for these--which means the first move up, they won't necessarily adjust. Typically, it might be 50, 75, or 100 basis points of a rate move up. So, let's say we move 40 basis points up, then not all of these are going to adjust higher, which is why they say there is some duration to bank-loan portfolios. There is some interest-rate risk. It's much less than your typical intermediate- or long-term bond fund, but there is some. So, you certainly want to go in knowing that's the story. We saw, on the other side, TIPS funds. People were shocked a couple of years ago when interest rates rose but inflation did not because TIPS are really meant to protect against inflation risk, not interest-rate risk. They are related but not the same, so you want to make sure that people who get into these bank-loan funds understand that it's not going to be a perfect protection against rising rates.

Benz: And nor should it be a cash substitute.

Kinnel: Not at all.

Benz: So, in terms of specific ideas, you mentioned that closed-end funds could be worth some additional investigation. How about in the open-end universe?

Kinnel: At the more cautious end is Fidelity Floating Rate High Income (FFRHX)--though, it has actually taken its cash stake down a little bit in the last year or so. So, I don't want to oversell it as this perfect fund, but it held up beautifully in '08, and it is at least a little on the more cautious side. So, that would probably be at the top of my list.

Benz: Russ, thank you so much for being here.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com. 

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