Bank Loan Funds: What They are and How They Work

 

bank loan fundsBank loan funds invest in loans made by banks to corporations with floating interest rates.  One of the reasons that investors like bank loan funds is that they can provide protection against rising interest rates and a high yield at the same time.  However, there are also several important drawbacks to consider as well.

 

How bank loan funds work

The loans that bank loan funds invest in have rates which are tied to a measure of short-term term interest rates (for example LIBOR). The loan typically calls for the borrower to pay a variable short-term interest rate, plus a fixed interest rate. The short-term interest rate component is usually reset every 90 days.  Right now, the fixed rate for new bank loans averages around 6.0%.  However, the fixed interest rate can be significantly higher or lower depending on the credit status of the borrower.

There are two interesting characteristics of bank loans

  1. They typically can be re-paid by the borrower at any time without penalty.  This makes them like a bond which is perpetually callable at face value.
  2. They are superior to bonds in terms of credit standing. Assuming that a company has both bonds and bank loans outstanding, the bank loans almost always have stronger legal claim to the company’s assets in bankruptcy.

 

Here are some key concepts to consider before investing in bank loan funds.

  1. When rates rise, bank loan funds do not lose value. Yields on bank loans are directly tied to short-term rates. If rates rise, so does the yield being paid on bank loans. Therefore, rising rates do not result in bank loan funds falling in value like they would for a traditional bond mutual fund.
  2. Bank loan funds hold risky debt & have volatile performance. According to JP Morgan, the average bank loan default rate for the last 20 years is around 4.0%. However, during the 2008 financial crisis, the bank loan default rate reached as high as 14%. Bank loans had a negative total return of 29% during 2008, only to bounce back with a positive 41% return the following year, according to Morningstar.
  3. The capital appreciation of bank loans is limited (unless the loans they own are trading significantly below face value). The underlying assets of a bank loan mutual fund tend not to trade at a premium to their face value. If the rate which a corporation pays on a bank loan is significantly higher than the current market, the corporation will refinance the loan. Because of this, bank loans don’t trade at a price that is above where they can be pre-paid (face value). However, there is room for appreciation if a bank loan is bought at level below the loans face value. Bank loans are currently trading in the neighborhood at 90- 95 cents on the dollar, providing room for a small amount of appreciation.

How do bank loan funds compare to high-yield mutual funds?

The performance of bank loan funds and high yield funds is highly correlated, meaning when one moves the other tends to make a similar size move.  To be exact, they have a 0.86 correlation. (A 1.0 correlation means that the two move 100% in tandem.) However, high-yield funds have done better than bank loan funds over the last 5 years in terms of absolute returns. High yield funds had an average total return of 5.37% versus 1.98% for bank loan funds.

There are two reasons why high-yield  funds have outperformed (from a total return standpoint) bank loan funds.

  1. A declining interest rate environment. While this decreases yields for both, falling interest rates increase the value of the holdings of high yield funds.
  2. High yield bonds typically pay 1 or 2% more interest than bank loans.

Both high yield and bank loan funds have annual expense ratios which are 20 to 30% higher than typical mutual funds.

 

What’s the Bottom Line?

If the US is entering a multi-year period of rising interest rates, bank loans funds should outperform high-yield bond funds, while providing a similar yield.

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