Loan funds lure those willing to trade risk for yield

MAY 13, 2012
By  Bloomberg
Individual investors are putting more money into bank loan funds, taking added risk in a search for higher yields and a hedge against inflation that might result from near-zero interest rates. U.S. floating-rate funds in April had the biggest inflows in 11 months, according to preliminary data from EPFR Global, a research firm. Investors poured $729 million into the funds, the most since $2 billion last May. The funds buy speculative-grade loans, a type of floating-rate debt that ranks senior to bonds and is used to finance buyouts. “Where else can you get 4% to 5% with zero duration? Few places, as far as I know,” said Christopher Remington, institutional money manager for Eaton Vance Corp., which oversees about $24.7 billion in floating-rate loans for retail and institutional investors. Duration is a measure of interest rate sensitivity. Most fixed-income investments fall in value as interest rates rise. The Fed has pushed investors into riskier corporate credit by suppressing long-term rates on safer Treasuries under a $400 billion bond-buying program known as Operation Twist. To aid the economic recovery, the central bank has also kept its target interest rate within a record-low range of zero to 0.25% since December 2008.

YIELDS AND RISK

The underlying loans returned 5.57% this year through May 4, compared with 3.08% through the comparable period of 2011, according to the Standard & Poor's/LSTA U.S. Leveraged Loan 100 Index. The funds that buy them aren't immune to losses. That's because the funds buy loans whose higher yield is accompanied by higher credit risk. Leveraged loans are rated below Baa3 by Moody's Investors Service and less than BBB- by S&P. The debt's interest rate generally resets on a quarterly basis. Some advisers contend that that's an advantage if rates rise, such as in response to a pickup in inflation, although holders could be left in line with other creditors if borrowers default. “I think it's a sweet spot right now,” said Maury Fertig, chief investment officer of Relative Value Partners LLC, which manages about $650 million on behalf of individual investors and wealth managers. “When stacked against other fixed-income assets, I think at least I have the opportunity for some capital appreciation, and in the event of higher rates, I'm not going to lose a tremendous amount of principal,” Mr. Fertig said. Bank loans account for about 15% of his clients' fixed-income portfolios. Bank loan mutual funds lost about 30% during 2008, compared with about a 26% decline for funds that invest in high-yield bonds, according to data from Morningstar Inc. This year through May 3, loan funds had gained about 4.8%, compared with 6.8% for high-yield funds. The yield on 10-year Treasuries was 1.88% last Monday, compared with about 3.15% a year earlier. Inflation was about 2.7% over the 12-month period through March, before seasonal adjustment, ac- cording to the Bureau of Labor Statistics. Mr. Fertig said he likes that the loans have less interest rate risk than many other fixed-income investments, because of their ability to reset rates, and that recovery rates on defaults are on average higher than those of traditional high-yield bonds. Investors on average recovered about 66% of their principal on bank loans in default from 1991 to 2012, compared with a recovery rate of about 41% on high-yield bonds from 1983 to 2012, according to a JPMorgan Chase & Co. research report. The loan funds offer attractive income and stronger protections in bankruptcy than some other types of high-yield debt, said Jonathan Bergman, chief investment officer of Palisades Hudson Asset Management LP, which oversees more than $1 billion. Not all advisers are stocking up. “People are so starved for current yield that I think it's pushing them into spots they otherwise wouldn't go,” said Mark Balasa, chief investment officer for Balasa Dinverno Foltz LLC, which manages more than $2 billion. “In 2008, these things got shelled.” The best-performing bank loan fund this year has been the Pyxis Floating Rate Opportunities Fund (HFRAX), with a return of 7.36% through May 3, according to Morningstar. The ING Senior Income Fund (XSIWX) ranks second, with a 7.3% gain. The debt may provide less protection against rising rates than some investors realize, since some loans have interest rate floors that are boosting yields, said Chris Cordaro, chief investment officer of RegentAtlantic Capital LLC, which manages about $2.2 billion. Payouts on such loans may take longer to increase if interest rates start to rise, he said. “If you're buying this thinking you're hedging away your duration risk, you might be in for an awakening,” Mr. Cordaro said.

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