Scott Page, who has managed the top-performing bank loan fund over the past five years, said that the debt is still attractive, even after a two-year rally.
That said, the investors who are pouring record amounts into funds such as his should temper their expectations, he said.
“This is a dull, 4% to 6% a year asset class, and it probably always will be,” said Mr. Page, who runs the $1.5 billion Eaton Vance Floating-Rate Advantage Fund Ticker:(EAFAX). “Loans aren't as outrageously attractive as they were a year ago, but they are still pretty attractive.”
Bank loan funds attracted $5.62 billion in net new money in January, a monthly record, according to Morningstar Inc., as investors sought protection from the possibility that a stronger economy and accelerating global inflation will force U.S. interest rates higher. Unlike bonds, which lose value when rates climb, bank loans have coupon rates that float with short-term interest rates, minimizing declines.
The funds, which buy loans made to companies with non-investment-grade credit, gained 9.4% last year and 42% in 2009, part of a broad rebound in debt markets following the financial crisis, data from Morningstar show. Those returns won't be matched this year, said Mr. Page and other managers, who predict gains more in line with those before the crisis hit.
'PEOPLE CAN GET HURT'
Investor interest in bank loans has grown since long-term interest rates began rising in October, depressing bond prices. The yield on the 10-year Treasury note climbed to 3.46% last Wednesday, from 2.6% on Oct. 31.
Bond prices have declined 2.2% since October, according to the
Bank of America Merrill Lynch U.S. Corporate & Government Master Index.
“People can get hurt in bonds,” Mr. Page said.
EAFAX returned an average of 5% annually in the five-year period ended Feb. 18, topping all rivals, according to Morningstar data. The fund uses leverage to enhance its returns.
A similar Eaton Vance fund that doesn't employ leverage gained 4.2% annually over the same period.
The funds typically buy five- to seven-year loans made to companies with debt rated below Baa3 by Moody's Investors Service and BBB- by Standard & Poor's. The loans provide a fixed spread over a benchmark, usually the London interbank offered rate, and reset about every 40 to 50 days.
Since 2009, loans have been pegged to benchmarks other than Libor because short-term interest rates have been so low, Mr. Page said.
Loans should outperform Treasuries this year unless the “economy falls back into a double-dip
recession,” said Jack Ablin, chief investment officer at Harris Private Bank. Mr. Ablin, who helps manage $55 billion, said that bank loans represent about 5% of his fixed-income portfolio.
From 1997 through 2007, bank loans returned about 5% a year, Otis Casey, a credit analyst at Markit Group Ltd., wrote in an e-mail. The default rate has averaged 3.9%, with a 70% recovery rate on defaulted loans, according to an April report from Eaton Vance.
“These funds are not without risks, but if companies are generally cleaning up their balance sheets, that risk looks smaller every day,” Jeff Tjornehoj, an analyst with Lipper, wrote in an e-mail.
The billions flowing into the funds are attracting notice.
Nuveen Investments Co., Pacific Investment Management Co. LLC, and
Prudential Financial Inc. plan to introduce floating-rate funds this year, according to regulatory filings.
Eaton Vance managed $22.7 billion in bank loans at the end of last year, spokeswoman Robyn Tice wrote in an e-mail.
The “steady” returns associated with bank loans disappeared in 2008, said Paul Scanlon, manager of the $456 million Putnam Floating Rate Income Fund.
The S&P/LSTA U.S. Leveraged Loan 100 Index fell from about 90 cents on the dollar in August 2008 to less than 60 cents four months later, according to data compiled by Bloomberg.
Bank loan investors, including hedge funds, relied heavily on borrowed money, Mr. Scanlon said. When markets froze in 2008 and loan prices fell, those leveraged investors were forced to sell, driving prices even lower.
An increase in defaults by companies with too much debt contributed to the decline, Mr. Scanlon said.
“They got slaughtered,” he said.
In a December 2008 interview with Morningstar, Mr. Page said that the selling was overdone and that loans represented “a significant opportunity” for investors.
Prices soon rallied as credit markets returned to normal and the U.S. economy began to recover. The loan index now stands at 96.42 cents, compared with an all-time high of 101.32 in 2005.
Bank loan investors hoping to take advantage of an increase in short-term interest rates this year may be disappointed. Returns on new loans may shrink because companies have been able to refinance at lower rates, said Craig Russ, co-manager of EAFAX.
Burger King Holdings Inc., one of the loans his fund owns, borrowed money in October and is already looking to refinance, he said. Burger King paid 4.5 percentage points above a benchmark for its October loan, according to data compiled by Bloomberg.
The new loan, Mr. Russ said, would be 3 percentage points above a slightly lower benchmark.
8% RETURN
Interest rates on new loans have dropped for six straight months to 4.32 percentage points more than benchmarks, according to S&P's Leveraged Commentary and Data.
Loans could return 7% this year as an asset class, Mr. Scanlon said.
Jonathan Blau, head of global leveraged-finance strategy at
Credit Suisse Group AG, looks for gains of 5% to 8%, he wrote in an e-mail.
Margie Patel, who manages more than $1 billion for
Wells Fargo & Co., isn't putting bank loans into her two mutual funds. High-yield bonds and stocks will both beat loans this year, she said.
“I don't think loans are going to blow up, but in a market where risk takers will be rewarded, other opportunities are more compelling,” Ms. Patel said.
Still, bank loans probably will benefit from an improving economy, said Elizabeth MacLean, portfolio manager of the $3.4 billion
Lord Abbett Floating Rate Fund.
“This is an attractive time to be taking credit risk,” she said.
Forecasters at S&P expect record earnings for the companies in the S&P 500 this year, said Howard Silverblatt, an index analyst for the ratings company.
Three-month U.S. Libor rates will climb to 63 basis points by the fourth quarter, from 31, according to economists surveyed by Bloomberg.
“When short-term rates do rise, they will snap up quickly,” said John Bell, who manages $2.5 billion in bank loan products at Loomis Sayles & Co. He didn't lay out a timetable for rate increases.
'STUPID STUFF'
In the leveraged-loan market, the trailing 12-month default rate among U.S. issuers fell to 2.5% last month, down from 11.5% a year earlier, according to a February report from Moody's.
“This isn't rocket science,” said Mr. Page, who added that he doesn't factor in predictions about the growth rate of the U.S. economy or the trajectory of interest rates when selecting investments. “What we want to know is, will a given company stay out of trouble and be able to pay us back?”
Risk will creep back into the market as spreads shrink and lower-quality companies seek loans, Mr. Page said.
“We will see credit excesses some day. It's human nature,” Mr. Page said.
“Wall Street will always provide people with an opportunity to do stupid stuff.”
