Bank Loan Funds - A Primer
In an environment of rising interest rates, most people tend to simply accept their losses when it comes to fixed income investments due to their decreasing value in this type of economic environment. But oftentimes they forget another option to traditional bond investment—bank loan funds, also referred to as prime rate funds. Though at times they can be risky, bank loan funds provide an investment option versus poorly-performing fixed income investments, such as traditional bonds, in a period of rising interest rates and high inflation. Also, since bank loan funds have little to no correlation to the stock market, they can serve as a hedge against declining stock prices. As an alternative fixed income investment, bank loan funds can be beneficial in stabilizing the volatility in a portfolio.
Bank loan funds consist of loans made by banks or other financial institutions to companies that are often below investment grade. The loans are often used to purchase and/or build plants, equipment, real estate, or they might be used to fund buyouts, mergers, or to acquire a company. The bank loans that comprise the funds are short- or intermediate-term in nature, with maturities of typically 2 to 10 years whose interest rates typically reset every 30, 60, or 90 days. These loan reset dates are much shorter in length than high-yield bonds, which typically do not reset. Also, despite the risk of losing money due to defaults on the loans, most bank loan funds only purchase senior secured floating rate loans, which maintain the highest priority of claim on the borrower’s (in this case, the company’s) cash flow. This means that if the purchase, project buyout, merger, or acquisition the loan was funding fell through, the bank loan would take precedence over all other debt for repayment and would also be secured by some sort of collateral. Some common forms of loan collateral include inventories, cash, real property, patents, stock, or other assets. This helps to reduce the portfolio’s overall volatility and potential for loss, especially during periods of time when the market is uncertain or unstable.
For instance, during the period of January 1, 1992 through December 31, 2004, senior secured floating rate loans matched the performance of U.S. 10-year Treasuries while also providing a return within 1.10% of corporate bonds and less than 1.00% of mortgages. Recently, such funds have been yielding nearly 7.00%, with the best performance exceeding 7.00%, well above the 4.64% benchmark 10-year Treasury yield. The yields on bank loan funds are typically higher because the borrowers have sub-investment-grade credit ratings, also called high-yield, high-risk, or “junk” debt typically rated BB or lower. This has attracted many investors, despite the inherent risks involved.
Not only are the senior secured floating rate loans that make up bank loan funds producing a better return in some cases, but they are also proving to be less volatile than other traditional forms of investing. These loans have demonstrated lower price volatility than high-yield bonds, mortgages, corporate bonds, U.S. 10-year Treasuries, and even the S&P 500. The rate paid by a senior secured floating rate loan also “floats” at a pre-determined spread over a particular reference rate. The London Interbank Offered Rate (LIBOR) is commonly used as that point of reference with the interest rate held in lockstep until it is reset every 30, 60, or 90 days, which is the typical reset term for the loans within a bank loan fund. Please note that in the 1990s these funds and loans were predominantly known as Prime Rate Funds and Prime Rate Loans respectively because they were tied to the U.S. Prime Rate. As the Prime Rate became more of a rate charged to individuals (consumer loans as opposed to corporate loans) and LIBOR was adopted by banks (for corporate loans) as the new benchmark, the words Prime Rate on bank loan funds were dropped.
Of course, despite the positive performance history of senior secured floating rate loans, they can still be speculative instruments and past performance is certainly not a guarantee of future results. Most managers of bank loan funds which utilize these types of investments are diligent about the types of loans they buy, the size limit, and how long they are held, but one can never be too cautious with their investments. Bank loan funds have high credit and liquidity risk, which should also be taken into account before choosing to invest in such a fund. However, defaults on senior secured floating rate loans have dropped significantly over the years due to increased diligence in the market. The default ratio should stay low as long as the economy remains healthy. The Moody’s Junk Bond Default Ratio is approximately 1.7% currently. Furthermore, the default rate of bank loans have historically been approximately two-thirds that of junk bonds and is currently less than 1.0%. The good news is that many of the bank loan mutual funds have experienced few, if any, defaults. Historically, for example, Eaton Vance, which is one of the oldest players in the business and has one of the larger analytical teams, has owned 1,700 loans during the past decade and has only had 15 loans default. Highland, since it took over Stein Roe’s funds a couple of years ago, has not had a single default and Stein Roe had only one.
Credit risk is also significantly reduced with the knowledge that the secured assets in collateral can be sold to pay off the loan. Additionally, the average recovery rate on bank loans historically has been 80 cents on the dollar, compared to 30 cents on the dollar for high-yield bonds, due to the senior creditor status of the loans.
Liquidity can also be an issue because many funds allow investors to buy shares whenever they want. However, most bank loan funds only offer quarterly redemptions. Very few bank loan funds offer monthly or daily redemptions by holding more cash, which if they did would result in a lower yield or by holding junk bonds, resulting in a more volatile Net Asset Value (N.A.V.). At times, it is possible for a fund to refuse to redeem a portion of the amount tendered by investors. This is because either too many of the shareholders may attempt to redeem their shares at the same point in time or try to redeem too much of their shares at one time. For example, this happened to the Highland Floating Rate Fund a few years ago when it was managed by Stein Roe. It also happened in August of 2007. Investors initially received only a portion of the amount of monies that they attempted to redeem and had to wait until the following quarter to obtain the remainder of their monies that they had previously tendered.
Pricing with regard to liquidity can also be tricky. The Securities and Exchange Commission strongly encourages bank loan funds to utilize outside pricing services. These pricing services estimate the value of each loan on a daily basis. Bond funds frequently use pricing services as well to price infrequently traded bonds such as corporate and municipal bonds. The good news is that, because trading volume has increased on bank loans, pricing is much more efficient than even five years ago. This, along with the utilization of pricing services, has made bank loan funds significantly more liquid and, as a result, more viable investments. Of course a market such as the one in the July/August time frame of 2007, when very little trading in fixed income securities other than treasuries was occurring, pricing problems can occur as well.
The bottom line is that advisors and investors must still do their homework. Credit analyses and due diligence need to be performed to ensure that when investing in these vehicles, the return is worth the risk taken. Despite some of the risks involved, bank loan funds can be a good balance against volatility in a period of rising interest rates, and can provide excellent returns in such an environment.