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Bank Loans Not the Same as Money Markets

The risk of bank-loan defaults is muted at the same time investor demand for such products remains elevated, but this volatile asset class is not for near-term cash needs, says Fidelity's Eric Mollenhauer.


Sarah Bush: Hello. My name is Sarah Bush, and I'm an analyst with Morningstar at the Morningstar Investment Conference. I'm here today with Eric Mollenhauer, manager on Fidelity Floating Rate High Income.

Thank you, Eric, for joining us today.

Eric Mollenhauer: Thanks for having me.

Bush: You took over Fidelity Floating Rate High Income about a year ago, in April 2013. Can you talk just little bit about what you've been doing with the portfolio and any changes you've taken during that time frame?

Mollenhauer: Sure. When I took over the portfolio I said there were a few things that I wanted to do with it. First, the cash balances in the portfolio typically run in the 10% to 12%, 13% range. And I felt given the liquidity in the market that we could bring that down a little bit and get that cash invested more.

So, we said we were going to bring cash down from 12% to 5% to 7%. We've done that. We talked about becoming more heavily invested in the names that we like, reducing the absolute number of issuers in the portfolio. We've gone from probably 375 names to closer to 320 names. And the thought process behind this is that, we invest a lot in research, we have a lot of analysts covering companies, and I really want to make sure that the portfolio is positioned that way, that we're really heavily investing in our analyst teams' best ideas. So, by bringing it down, we're focusing more on our researchers' best ideas.

I also talked about bringing the bond exposure down in the portfolio. We'd been running close to double digits in bonds. And I wanted to bring that down for a couple of reasons. One, [the fund is] a floating-rate product. I think if investors want exposure to high-yield bonds, which were typically in the portfolio, they can do that by making choices to invest in a more high-yield product. Two, I didn't want to add a lot of duration [a measure of interest rate sensitivity] to the portfolio. And three, I just didn't see the relative value in high yield relative to loans, especially today, where a BB bond could be trading at 4.5% for 10-year, fixed-rate-type exposure. A BB loan could yield me 4% where I'm secured by the assets and I have floating-rate exposure and no duration. So the relative-value argument to me wasn't as compelling.

So, the big changes people would see in the portfolio is cash is lower, fewer securities, and less bond exposure. But at the end of the day, we've also committed to maintaining the conservative positioning of the portfolio. So we've maintained the BB overweight, the B underweight, as well.

Bush: We just spent a little bit of time at our panel on bank loans talking about the outlook for the bank-loan market, and you've indicated their valuations are attractive relative to high yield. But could you expand kind of more broadly on what does a default outlook look like and how you're thinking broadly about those opportunities?

Mollenhauer: Sure. I think the default outlook for the next couple of years is really pretty minimal. I mean, S&P and Moody's talk about 2% to 3% default [rate] outlooks, and I can't really find any reason to disagree with that. You look, there's been a tremendous amount of demand and new-issue flow in the bank-loan market, and what that's done is it's pushed out the maturity wall, or the amount of companies that have near-term maturities, out to 2017, '18, '19, '20 and beyond.

In terms of near-term maturity risk, there's not a lot out there to kind of put these companies at risk. From a fundamental perspective, the economy isn't growing as fast as people would like, but 2% GDP growth can translate into revenue growth for these companies. It's slight, but it's enough to cover increasing costs. And that's just fine for leveraged credits. When revenues start to turn negative, that's when you start to get worried, but the slow-growth environment is actually pretty good.

For me, I think the default environment is kind of muted. The outlook from a return perspective, I think, we're playing for our coupon. The market's trading at par. Where you're going to outperform is by avoiding the blow-ups and the downside risk, and, hopefully, at the end of the day, we're getting that 4%-type coupon return for the next couple of years.


Bush: In the market today, we've seen a lot of flows into the market, and you see some opportunities. Are there particular parts of the market that you particularly like today, or as you're looking to avoid blow-ups, are there parts of the market that you're avoiding?

Mollenhauer: I think the market is trading really tight because there has been so much demand. And so, where we're really seeing the opportunities is in the primary or new-issue market. And this is where we can buy loans at a slight discount to par [value of 100], 99 to a shade under par. Loans are called any time, but new-issue loans typically come with at least six months to one year of call protection, so we can kind of lock in that coupon for at least six months. Whereas in the secondary market, you're kind of seeing loans bid above par. It's harder to trade, and you have less call protection.

Right now, the opportunities seem to be more in the new-issue market. Now, that being said, the new-issue market is kind of pretty aggressively focused because there's just been a lot of new issuance. So you really have to kind of do the credit work and really focus on what new issues you're buying. But from a secondary opportunity, there's not a lot out there to generate a lot of capital appreciation. From a new-issue perspective, it's really picking through and making sure you're making the bets on the right companies and avoiding the ones that have some risk down the road or just aren't priced appropriately for those risks.

Bush: And I wanted to ask you just as a wrap up. We had one question come up at our panel which I thought was interesting. We had a gentleman ask us, if people should think of these as money market-type funds that have attractive yields and not a lot of duration. What is your thought on that question?

Mollenhauer: I can see why people want to make that connection; these are secured assets with pretty stable net asset values historically. The problem is that these are leveraged companies. These are non-investment-grade companies. They do have issues, and there is blow-up risk or credit risk in these portfolios. And there is liquidity risk and other things.

I think leading up to 2007-08, people felt pretty good because the loan market had never had a down year. It just kind of always returned that kind of low-single-digit, mid-single-digit type return. But 2008 happens, and all of a sudden the entire market is trading at $0.60 on the dollar.

The message is, there is volatility in this asset class. There is a chance that over time your NAV will drop. So, for the customer or the investor who is out there looking to buy a house in six months and looking to just increase the yield they're getting on the cash that they've got for that down payment, this is not the appropriate place because if a shock to the market happens, you could see your principal drop by a few points or more.

Our market has shown, that over time the credit quality and the security coverage that we have in these loans tends to go like [a U shape]; you have times where it goes up but we recover that. But there is that U in the pricing that can come up that make this not an NAV-of-$1-type environment. So, it's more a two-year investment, I would say. If you're looking for a couple of years, this is a great place to get some extra yield. A six-month money market type thing? It's not the same.

Bush: Thank you very much, Eric, for joining us today.

Mollenhauer: Oh, thanks. Thanks so much for having me.

Bush: Great. For Morningstar, I'm Sarah Bush. Thank you.

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