Bank-loan funds suffer during credit crisis

Nov 26, 2007 @ 12:01 am

By Dan Jamieson

The credit crisis has hurt bank-loan funds, a sector that until recently has remained fairly stable.

The funds buy securitized corporate loans made by banks and pay a variable rate of interest, currently at about 6.5%. In theory, the funds are a nice complement to fixed-rate-bond portfolios.

But bank-loan funds were up just 1.75% year-to-date through Nov. 15 on a total-return basis, which was the second-worst-performing category among taxable bonds, just ahead of high-yield funds, which rose 1.68%, according to Morningstar Inc. of Chicago.

Bank-loan funds haven't seen so much volatility in the past five years, observers said, since the last recession affected some loans.

Most of the recent damage came in July, when funds in this group dropped 3.2%, said Paul Herbert, an analyst at Morningstar.

Uneasiness caused by the subprime mess, and an imbalance in supply and demand for loans, caused the price drop, observers say.

The asset class doesn't fare well during recessions, according to fund managers, and some of the current weakness may be in anticipation of an economic slowdown.

This past summer, several large corporate acquisitions financed with bank loans drove up the supply of securitized bank paper. About $230 billion came to market in July, said Michael Bacevich, co-portfolio manager of the Hartford Floating Rate Fund, offered by The Hartford (Conn.) Financial Services Group Inc.

In addition, half or more of the demand for bank loans has been coming from institutional buyers of collateralized loan obligations. But these buyers "disappeared nearly overnight in July," Mr. Bacevich said.

That is because CLO investors also buy collateralized debt obligations, and "a lot of them had their heads handed to them in the CDO space," he said. "They stepped back from [anything] structured and leveraged" even though no CLOs have been downgraded, Mr. Bacevich added.

"We believe there was quite a bit of selling by the hedge fund component of our market" during July, said Craig Russ, co-manager of the Eaton Vance Floating Rate Fund, offered by Eaton Vance Corp. of Boston. "As [hedge funds were] looking for assets to sell, [bank loans were] a very liquid asset" that the overleveraged hedge funds could sell," he said, noting that trading levels in bank loans have doubled from those during the summer months.

Mr. Herbert doesn't think that demand will return quickly.

"You have to expect defaults will pick up from where they are now," he said. "So demand may not be what it was."

Some high-yield managers, though, are stepping in to pick up some of the slack, Mr. Herbert said.

Junk fund managers "feel they're getting more security at a cheaper price" by buying bank loans instead of corporate paper, he said.

The recent drop in bank-loan funds ate up nearly a year's worth of yield, said John Nowicki, president of LCM Capital Management LLC in Chicago. "That's why we don't deal with [them]," he said.

"People are under [the] impression that they don't stand to lose anything" from bank-loan funds, Mr. Nowicki said. "But that is definitely not the case ... You can't get 6.5% [yields] without taking a little risk."

Securitized bank loans are below-investment-grade credits, Mr. Herbert said. "That's why from time to time, you'll see defaults or a perception of credit quality weakening" in these securities, he said.

Although bank loans are usually secured by assets, "they're on a par with high-yield [bonds] to a degree," Mr. Herbert said.

"If you believe we are headed into recession and that defaults will increase materially, [you would] underweight credits and loans," Mr. Bacevich said.

Mr. Herbert compared the current period to the market weakness in bank-loan funds from 2000 to 2002, when some telecommunications bonds defaulted, and bank-loan funds suffered similar volatility.

Lower prices might have made the funds a better deal, observers said.

Mr. Russ said the bank-loan market will see more defaults regardless of whether a recession takes hold.

"The average (default rate) is 2% to 3% per year; today, we are under a half a percent," he said. "We really have only one way to go."

However, expectations are that default rates will still remain below historic levels, Mr. Russ said.

"Today's prices suggest default rates of greater than 10% to 12%," he said. With bank-loan securities trading at about 96% of par, they "represent really terrific value from a historic perspective," Mr. Russ said.

The products still work as a hedge to fixed-rate bonds, Mr. Bacevich said. "Loans are still negatively correlated to investment-grade bonds," he said.

Mr. Herbert agrees, saying that data show that the funds seem to be a "pretty good diversifier for a bond portfolio" because of their floating rates.

Dan Jamieson can be reached at djamieson@crain.com.

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