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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.

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