Will bank loan funds bite financial advisers?

Bank loan mutual funds have received unprecedented interest from investors this year as short-term interest rates look to stay low for a long time.

The trend is leading to growing concern that some financial advisers could be caught by surprise if sentiment for the loans turns around and outflows lead to negative performance.

Bank loan funds had $46 billion in net inflows through the end of August, the most of any mutual fund category at Morningstar Inc., and already four times the net inflows they received last year.

The total assets in those funds now top $121 billion, up from just $26 billion at the end of 2009.

“The mistake advisers make over and over again is taking a good idea and overusing it,” said Rob Isbitts, chief investment officer at Sungarden Investment Research LLC.

It is easy to see why the loans have been so popular.

The loans are short-term, below-investment-grade issues with yields tied to short-term benchmarks such as the London Interbank Offered Rate. If short-term rates move up, which many expect them to do at some point, the loans will benefit.

Bank loan mutual funds stand in stark contrast to traditional fixed-income funds, which are negatively affected by rising rates.

2nd place

The average bank loan fund has a return of 3.62% this year, second only to high-yield-bond funds, thanks to its high yield and low duration, not its ties to rates.

Unfortunately for bank loan investors, it has been long-term rates that have been driving the market so far, which have no impact on bank loan yields. The 10-year Treasury went from 1.6% in early May to as high as 3% this year, but short-term rates have essentially stayed at zero.

Moreover, bond guru Bill Gross, portfolio manager of the $250 billion Pimco Total Return Bond Fund (PTTAX) at Pacific Investment Management Co. LLC, thinks that short-term rates will stay low for years to come.

“The fed funds [rate] will then stay lower than expected for a long, long time,” he wrote in his most recent market commentary.

Great expectations

“Right now, the market [and the Fed forecasts] expects [the] fed funds [rate] to be 1% higher by late 2015 and 1% higher still by December 2016. Bet against that,” Mr. Gross said.

“When sentiment turns, it’s going to be very ugly,” said Ken Volpert, head of the taxable-bond group at The Vanguard Group Inc.

Bank loan funds have already gotten a taste of what can happen when investors turn on them.

In 2010, when potentially rising rates first got the attention of investors, bank loan funds took in $15.6 billion, up from $3.5 billion in 2009. By mid-2011, as the debt ceiling debate and troubles in Europe weighed on the market, it became clear that rates weren’t going to rise anytime soon.

That August, investors yanked $7 billion from the funds.

That month, the average fund lost more than 4%, according to Morningstar.

Mr. Volpert likened the potential losses to those seen this year in emerging-markets-bond funds, which were the fixed-income du jour of 2012.

Emerging-markets debt had $21 billion in net inflows last year, double that of bank loan funds, but the category cooled off considerably after the Federal Reserve’s taper talk in June.

Outflows

That led to $25 billion in net outflows over 17 straight weeks, according to a Wall Street Journal report.

Thanks to the outflows, the average emerging-markets-debt fund lost 6.7% through Oct. 4, according to Morningstar.

It is the second-worst-performing fixed-income category. Only long-term-government-bond funds have fared worse.

Not everyone is buying into the doom and gloom surrounding bank loan funds, though.

Mr. Isbitts said that the there is still less risk in bank loans than in high-quality bonds, which no longer have 30 years of falling rates to propel returns.

“High-quality bonds have a much bigger setup for disaster than a 5% or 10% allocation to bank loans,” he said.

Matt Reiner, chief investment officer at Wela Strategies LLC, has been adding bank loans in anticipation of rising rates over the long term, but he is keeping a close eye on the inflows. “The inflows do scare me a little bit,” he said.

“It’s not the biggest market. It’s something we’re monitoring.”

Because the specter of rising rates is likely to persist for years, Diane Pearson, wealth adviser at Legend Financial Advisors Inc., thinks that money isn’t likely to start rushing out of bank loans anytime soon.

“We’ve got a long window ahead,” she said.

Like Mr. Reiner, Ms. Pearson is keeping a close eye on flows, particularly in the bank loan funds that her clients own.

“You want to make sure the funds you’re using don’t become overweight,” she said.

“Make sure you know if the managers are willing to do a hard or soft close. It goes back to due diligence.”