Mutual funds that invest in floating-rate bank loans have emerged as one of the most popular strategies for protecting portfolios against rising interest rates
Mutual funds that invest in floating-rate bank loans have emerged as one of the most popular strategies for protecting portfolios against rising interest rates.
The trouble, however, is that those pesky interest rates have refused to budge from their historic near-zero lows. That raises the question of whether the strategy makes sense right now.
Before answering that, let's look inside such funds.
They invest in loans with yields that adjust about every 60 days. As a result, the fixed-income portfolios are essentially immune to the negative effects that rising rates have on traditional bond funds.
The individual bank loans, which are made primarily to below-investment-grade companies, pay yields of about 4.5 percentage points above the short-term London interbank offered rate, which is currently at 30 basis points.
Loan yields in the 5% range, combined with an average return by mutual funds in the category of nearly 42% in 2009, helped propel more than $16 billion in net inflows into bank loan mutual funds last year.
That momentum has carried over to this year, with net inflows reaching $14.5 billion through March, despite average fund returns of 9.4% in 2010.
The recent flows compare with just $3.8 billion in net inflows in 2009 and net outflows of $8.6 billion in 2008, according to Morningstar Inc., which identifies just 30 open-end mutual funds as distinctly in the category.
While the underlying loans are mostly senior-secured, investors jumping into the strategy should understand that these are not risk-free investments, according to Sarah Bush, a senior mutual fund analyst at Morningstar.
“In the rush for yield, people have to be mindful of the credit risk because there are a lot of junk-bond-rated companies in this space,” she said. “And the loans can be less liquid, which would make it harder for a manager to sell if there were heavy redemptions.”
That particular risk, Ms. Bush added, should not be ignored in light on the recent pace of inflows.
“If the money comes in quickly, it can also go out quickly,” she said.
The risk of hot money is just one possible downside associated with the rising popularity of the category.
“If there's a lot of demand for these loans, it becomes a seller's market and the spreads start to go down,” said Jeff Bakalar, who helps manage $10 billion in bank loan portfolios at ING Investment Management.
Those spreads, or yields above Libor, already have compressed on average to 3.85%, from 4.25% a year ago, Mr. Bakalar said.
The total bank loan market is estimated at between $1 trillion and $1.5 trillion. Roughly half of the total is held by the lending institutions, with the rest sold to investors, including mutual funds, structured products and specialty finance companies.
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The growing mutual fund appetite is being offset partially by less demand from collateralized-debt-obligation structured products, which attracted just $5 billion from investors last year and $1.5 billion through March of this year.
“What we're seeing is a healthy transition in the form of a broadening base of buyers,” said Jean Joseph, co-manager of the Goldman Sachs High Yield Floating Rate Fund Ticker:GFRAX).
Launched this month, the fund is the latest entry in the bank loan mutual fund sector.
Michael Goldstein, lead manager on the fund at Goldman Sachs Asset Management LP, estimated that mutual funds currently represent about 10% of the bank loan market, although that share is growing.
“During the fourth quarter of last year, mutual funds represented 15% of new bank loan issuance, and that jumped to 30% during the first quarter of this year,” he said. “That's an affirmation of a changing investor mix, but this is still by no means a crowded field.”
Whether the space is getting crowded or not, the most bullish case for bank loans still depends on the economy's gaining enough strength to create the kind of borrowing demand that will drive Libor back toward its historical average of more than 4%.
Questions, observations, stock tips? E-mail Jeff Benjamin at jbenjamin@investmentnews.com.
