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ETF Specialist

Why Bank Loan Funds Need Active Management in This Market

Illiquidity and credit risk make indexing less effective in the bank-loan sphere.

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Higher yields, floating rates, and a higher position in firms’ capital structure form the chorus that sings the siren song of the bank-loan market. These are obligations typically issued by companies that have received a below-investment-grade rating, hence the higher yields. The coupon rate for these obligations float based on Libor, so investors are protected from interest-rate risk during periods of rising interest rates. And they offer greater protection than a traditional high-yield bond in the case of a default, so they do not typically suffer as much as high-yield bonds when credit spreads widen.

Over the 10 years through March 2020, the average 12-month yield for market-value-weighted index funds in the bank-loan Morningstar Category was 1.35 percentage points higher than that of similar funds in the corporate bond category. But there is no such thing as a free lunch. Risk and reward are highly correlated in the fixed-income market. For instance, this strategy fell by 20.72% between Feb. 19, 2020, and March 23, 2020, the peak to trough of the coronavirus financial crisis.

Neal Kosciulek does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.