Skip to Content
Fund Spy

The Outlook for Bank-Loan Funds

Fears of rising interest rates have faded some, but this category still has appeal.

It may be hard to remember now, but one of the big stories of late 2010 and early 2011 was the wild popularity of the bank-loan category. Between September 2010 and June 2011, it saw an estimated $30.3 billion in net inflows. Flows turned sharply negative in August, but for the year to date through November, the category ranked fifth among all U.S. mutual funds in net inflows and had grown to $57.6 billion in total assets, an increase of more than 70% from August 2010.

The group's surge in popularity wasn't surprising. Bank loans, which typically finance leveraged companies with plenty of credit risk, offered comparatively attractive yields at a time when investors were searching for income. And just as important (given fears at the time about inflation and rising yields), the rates on leveraged loans float, regularly resetting to a spread above LIBOR. This floating-rate feature makes the loans relatively insensitive to movements in interest rates. The mechanism isn't perfect: Many loans issued in the current low-rate environment carry LIBOR floors and are therefore priced at, say, the greater of 150 basis points or LIBOR plus a spread. As a result, LIBOR would have to rise above the specified floor before rates on the loans would increase. However, if we experienced a sustained and significant rise in short-term yields, the rates on bank loans would rise with LIBOR, making them relatively immune to rate-driven principal losses.

While the fear of rising interest rates has faded some thanks to recent turmoil and the Federal Reserve's commitment to keeping short-term rates low, bank-loan valuations mean that the category still holds some appeal.

Like many risky asset classes, bank loans got pummeled in the third quarter with the typical fund losing 5.2% in August. That volatility provided a sharp reminder that, despite their floating rates, bank loans are credit-sensitive and not an appropriate substitute for cash or other high-quality, short-term investments. However, it may also provide an entry point for investors. As of early December, the average bid price on the S&P/LSTA U.S. Leveraged Loan 100 Index was 90.3, down from 96.0 in April. That leaves room for price appreciation that's otherwise often absent: Loans are typically callable at par, so there's little upside when loans trade at or close to par value, as many were earlier in the year.

Renewed fears of a recession or unexpectedly bad news from Europe could put more pressure on prices. So far, however, default rates remain low. Market observers argue that corporate balance sheets are flush with cash and that companies have been cautious about taking on new projects. Indeed, according to J.P. Morgan Chase, refinancings accounted for 60% of issuance in the bank-loan market for the year to date through November. Some companies paid up--in the form of higher spreads--to extend their loan terms, thus reducing short-term refinancing risk. Finally, some managers have noted that a slow-growth environment can be hospitable for credit-sensitive bonds and loans because as long as companies are generating cash, they can pay down debt.

Investors looking at bank loans should be prepared to sit tight through some volatility. Bank loans are less liquid than many other assets, including high-quality corporate bonds, and that can exacerbate losses when credit markets sour. Indeed, the average fund lost 30% in 2008 as highly leveraged CLO investors and investment funds hit with redemptions sold into an illiquid market. The investor base of the asset class has changed since then, with leveraged investors playing a smaller role. However, as the past few years have demonstrated, this is a category that can definitely lose money in the short term.