Christine Benz) Asset
inflows into bank-loan funds slowed toward the end of 2011, but
investors have demonstrated ample enthusiasm for the group during the
past year. More than $7 billion in new assets had flowed into the category
so far in 2012 through October. That's less than the amount that has
gone into some categories, but year-to-date inflows still represent more
than 10% of the bank-loan category's total assets.
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 a 12-month trailing yield of about 4.7%, nearly
2 percentage points higher than the median intermediate-term bond fund's
12-month yield. Although SEC yields aren't available for every fund on
Morningstar.com, many bank-loan funds still sport SEC yields of more
than 4%. (SEC yield provides a more current snapshot of prevailing
payouts than does trailing 12-month 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 argues 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
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 generally 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
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 is more than twice as high as is the case for intermediate-term
bond funds during the past five- and 10-year periods, 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. Because
investors typically have a better time sticking with more risk-conscious
funds (and this is true not just in the bank-loan sector), our analysts
tend to favor those offerings. Fidelity Advisor Floating Rate High Income(FFRAX),
one of the group's most cautious options, is one favorite. Morningstar
senior analyst Sarah Bush surveys the category and provides Gold-Rated
funds in this article.