Investors cool to bank loan funds and performance could be a casualty

Search for yield, along with a more predictable Federal Reserve, has investors dumping adjustable-rate bank loan funds

May 1, 2014 @ 11:44 am

By Carl O'Donnell

+ Zoom

Greater predictability from the Federal Reserve is prompting investors to dump adjustable-rate bank loan funds in search of juicer yields, setting the stage for a potential slide in fund performance, analysts say.

After 95 weeks of uninterrupted inflows that totaled more than $80 billion, bank loan funds saw nearly $300 million of outflows between April 9 and April 23, according to data from Lipper Corp.

The reversal may be an early indicator of a longer-term decline in the funds' appeal, analysts say. The main attraction of bank loan funds — protection against interest rate risk, thanks to adjustable rates — is increasingly insufficient to compensate for bank loans' low yields and poor creditworthiness.

“The most critical information about the Federal Reserve's interest rate normalization is in the rearview mirror,” so investors are putting less of a premium on protection from interest rate risk, said Brian Rehling, chief fixed-income strategist at Wells Fargo Advisors.

So far, the outflows have not been associated with a decline in the funds' performance, but sustained outflows could drive down funds' net asset values, according to Barry Fennell, a senior analyst at Lipper.

“You wonder, if too many assets leave at once, whether there might be some price volatility,” Mr. Fennell said. “That could come as a surprise to people who were treating these assets as a safe haven.”

Bank loan funds were in vogue all last year, when uncertainty about the Fed's bond-buying program reached fever pitch. In fact, net inflows topped $1 billion in over 22 nonconsecutive weeks in 2013. Total assets in the funds have more than doubled since June 2012, reaching $152 billion as of April 23, from $71 billion on June 20, 2012, according to data from Lipper.

As demand spiked, however, the fixed-income funds' yields plummeted to historic lows, according to the data. For example, Fidelity Advisor Floating Rate High Income Fund (FFRHX), the second-largest bank loan fund, today offers yields of only 2.56%, according to Lipper.

That's less than the 2.67% yield on 10-year Treasury bonds, which offer vastly lower credit risk, said Andrew Thompson, director of SC&H Financial Advisors Inc.

“The relative value of these funds is just not what it was before,” especially now that investors are less concerned about interest rate risk, Mr. Rehling said.

“This is just an example of supply and demand,” said Robert Polenberg, a data analyst at S&P Capital IQ. “If the value of the hedge [against interest rate risk] is gone and the yield is low, then people will lose interest and go elsewhere.”

Over the past couple of weeks, investors exiting bank loan funds have flocked to longer-duration, higher-yield fixed-income products, Mr. Fennell said. During this time, new money has flowed into high-yield corporate bond funds, emerging-markets debt funds and municipal bond funds, among others, according to Lipper.

The flows out of bond loan funds are likely to continue until yields bob back up to levels that investors find more appealing, Mr. Rehling said.

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