When interest rates start rising the advantage will likely go to portfolios such as the $1.2 billion ING Senior Income Fund Ticker:(XSIAX), which is virtually 100% invested in floating-rate bank loans.
The portfolio of mostly first-lien bank loans that are pegged to the London Interbank Offered Rate offers an efficient mechanism for capturing yield in a rising-rate environment.
While portfolios of fixed-rate loans, such as many traditional bond funds, tend to decline in value when interest rates rise, the floating-rate loans increase in value.
“The past two years has left a lot of people confused about loans,” said Jeff Bakalar, who is part of the team managing $10 billion worth of floating-rate-loan portfolios for ING Investment Management.
Part of that confusion, he explained, includes the mistake of associating funds such as his with money market funds or other cash management strategies.
“This is not a risk-free asset class, but it is a lesser-risk asset class,” he said. “These types of strategies have been sold as proxies for money market funds, but the risks involve supply and demand, as well as default risk.”
The default risk relates to the fact that the loans in the portfolio are all from non-investment-grade companies.
The fund carries loans from more than 300 different corporations.
The general strategy is starting to get back to normal, according to Mr. Bakalar, following two years of unusually high volatility. Prior to the recent market turmoil, the strategy typically generated an average annual total return of between 6% and 8%.
But in 2008, the fund declined by 40%, compared with a 30% decline by the S&P/LSTA Leveraged Loan Index. Last year, however, the fund gained 64%, while the benchmark gained 52%.
The use of leverage played a role in both the losses of 2008 and the gains of 2009. The portfolio is currently 11% leveraged long, according to Mr. Bakalar. In addition, returns last year were boosted by discounts on loans, which typically were selling at about 60 cents on the dollar.
Granted, floating-rate loans are still below par, at about 92 cents on the dollar. But that gap will evaporate on the first sign of rising rates, according to Mr. Bakalar.
“With the healing of the financial markets, the loan market is starting to function normally again,” he said.
The only thing missing now is higher interest rates.
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