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Late to the Bank-Loan Party

Those buying bank-loan funds now may be trading one risk for another.

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Last year was a banner year for bank-loan funds--or at least bank-loan fund marketers. An estimated $61 billion in net inflows flooded into open-end mutual funds, while bank-loan exchange-traded funds took in $6 billion. Those are big dollars for this once-small category, which has grown tenfold since late 2008.

It's not hard to understand why the asset class has drawn so much interest. For starters, bank loans offer relatively attractive yields; recently the average fund in the category had a 3.5% SEC yield. More important, floating-rate leveraged bank loans feature a floating interest rate that is set at a spread over Libor and periodically resets to capture changes in that rate. (Most more recently issued bank loans include a "Libor floor," and rates are set to a spread above the greater of that floor or Libor; eventually, though, a sustained increase in Libor would translate into rising yields).

The Trade-Off
That's a particularly attractive feature for investors worried about interest rates. Although bank-loan yields didn't adjust upward in 2013--short-term rates such as Libor are likely to remain anchored by the Fed for some time--they were also relatively unaffected by spikes in intermediate- and long-term yields that handed the Barclays U.S. Aggregate Bond Index its first loss in more than a decade.

Still, investors might be trading one risk for other, potentially just as potent, ones. The comparatively plump yields still offered by bank-loan funds are there in part to compensate investors for credit risk. Borrowers in the bank-loan market are typically companies with highly leveraged balance sheets and below-investment-grade--read "junk"--credit ratings. Indeed, while bank-loan investors have protections not typically found in the high-yield bond market, there's a significant overlap between issuers in these two asset classes. Bank loans can also turn illiquid when credit markets are stressed. As a result, bank-loan funds don't offer the same diversification from equity risk provided by high-quality bond funds.

Witness the bank-loan category's 30% loss in 2008; more recently, the category lost 4% in August 2011.

Diluted Appeal
All the dollars flowing into the category are arguably already limiting its appeal. Managers are eager to put cash to work, making this a borrower's, rather than an investor's, market. An increasing number of loans are coming to market with weakened investor protections ("covenant-lite" transactions), while borrower leverage ratios are starting to creep up. And spreads--the amount of additional yield that investors get paid for taking on credit risk--continue to contract. Finally, bank loans typically carry minimal call protection. As a result, a borrower can refinance at or very close to par, so there's limited upside. Many borrowers have been doing just that in recent years, reducing the yield that ultimately reaches investors.

For those still entranced by the bank-loan category's floating-rate charms, it's more important than ever to do your homework. With default rates low--today--many of the category's top recent performers are the most aggressive funds, holding large stakes in the riskiest, CCC rated loans and/or using leverage. Many of these funds suffered particularly hefty losses in the credit crisis and would be vulnerable to losses the next time credit markets sour.

Tread Carefully
Two of our favorite funds in the category, Gold-rated  Eaton Vance Floating Rate (EVBLX) and Bronze-rated  Fidelity Floating Rate High Income (FFRHX), feature experienced managers backed by significant analytical resources and a judicious approach to risk. (Fidelity's Eric Mollenhauer is new to the fund, but not to managing bank loans.) While the Fidelity fund is significantly more conservative, both funds tread carefully in the CCC rated reaches of the market and neither uses leverage.

Sarah Bush has a position in the following securities mentioned above: FFRHX. Find out about Morningstar’s editorial policies.