The hidden risks of bank loan funds

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Bank loans may seem like the perfect cure for today’s volatile and high markets. They earn a lot, just under 5%, as many of the companies that issue these securitized loans are rated below the investment grade. Plus, their interest rate is adjustable, so when rates go up, their coupons are reset upward. This is why bank loan funds are more resilient in a rising interest rate environment than bond funds.

There are other attractions. They take priority in a company’s capital structure, so in the rare event of default, loan investors typically get more capital back than bond investors. High yield junk bonds, which are overvalued by many measures, now yield little more than bank loans.

“When you see returns at about the same level, investors should favor loans over bonds because of this added protection,” said George Goudelias, portfolio manager of the top-rated company.

RidgeWorth Seix High Income Variable Rate

(ticker: SFRAX), up 13.5% over the past 12 months.

But bank lending comes with hidden risks, and one of the biggest is now emerging: the risk that companies will refinance their loans at lower rates, reducing investor returns.

The loans are repayable at par, so now that prices have risen, issuers have used strong investor demand to refinance at lower rates. The volume of re-priced loans broke records in January at $ 100 billion, compared to an average of nearly $ 30 billion in the previous eight months, according to S&P Global Market Intelligence.

“This is a case where demand is driving supply,” says Gershon Distenfeld, who oversees high-yield, premium credit at Alliance Bernstein.

Already, the current bank loan fund return – 3.95% – is lower than the 12-month average return of 4.11%, according to Morningstar. Goudelias believes that around 0.25 to 0.35 percentage points of the index return will be lost due to refinancing, but some could be offset by higher short-term rates. He notes that waves of repricing come and go. “It will pass,” he said.

THEN THERE IS THE RISK OF CREDIT, which can slam this sector when the economy weakens. It seems unlikely this year, with the Trump administration forecasting a fiscal stimulus, but investors should be aware that bank lending has performed poorly in times of risk aversion in the markets.

In the long term, Distenfeld considers high yield bonds superior to bank loans. To reduce interest rate risk and maintain a certain return, he recommends short-term high yield bonds, which he says offer better long-term returns and lower volatility than bank loans.

Michael Arone, chief investment strategist at State Street Global Advisors, believes investors should include loans in their high-yield basket, but realize that the opportunities for gains beyond yield are limited. “They are not an unknown investment opportunity,” he says.

Still, a 4% total return could look pretty good by the end of the year if stocks fall or rates rise, says Mark Fein, senior analyst at Lear Investment Management. To increase his income, he likes two closed funds,

BlackRock Floating Rate Income Strategies

(FRA) and

Invesco Senior Income Trust

(VVR), which give 5% and 6% respectively. Both trade at a small discount and use leverage to increase returns. For a bullish rate game without leverage, he likes the

BlackRock Floating Rate Income Portfolio

(BFRAX), which he describes as “rock solid” in terms of credit selection.

“It’s about having the right expectations,” says Krishna Memani, chief investment officer at OppenheimerFunds. “Bank loan funds are geared towards income rather than a variable rate. The variable rate is a two, but the main attraction should be a high level of income. Just recognize that there are risks that come with it.

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