Protection from rising rates won't be cheap once the crowds arrive.
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By Eric Jacobson | 06-17-10 | 06:00 AM | Email Article

We don't usually spend a lot of time trying to figure out which asset classes are going to be popular with investors in the future, but there's one sector for which predicting its ascent is usually easy: floating-rate bank loans.

Eric Jacobson is a senior analyst covering active strategies on Morningstar’s manager research team.

You wouldn't necessarily assume so based on recent trends. Until May's sovereign debt turbulence pulled some inflation fear out of the market, it had become conventional wisdom that interest rates were headed up soon, a good portent for bank loans. But while bank-loan funds have taken in a healthy chunk of assets--roughly $5.7 billion during this year's first five months--it's a trickle when compared with the massive inflows to the broader income-focused universe of taxable and municipal funds. Combined, those two groups took in nearly $120 billion during the same period, with a big portion of that sum going to core intermediate- and short-term bond funds.

They'll Be Comin' Round The Mountain When They Come
If you look at how investors have behaved in earlier periods, though, the record suggests many more will eventually sprint into bank loans right about the time the Fed begins jacking up short-term interest rates. Based on Chicago Mercantile Exchange data, current market sentiment tips in favor of a Fed funds (the Fed-controlled rate at which banks lend to each other overnight)hike by the end of January, and puts the probability of a hike by the end of April 2011 at roughly 85%.

The appeal behind syndicated floating-rate bank loans, of course, is that their income payouts are almost always tied to LIBOR (which normally moves with the Fed funds rate), and are designed to readjust up or down to its newest level every 90 days. On average then, the duration of a bank-loan portfolio often clocks in at well less than a year, so its price is affected very little by any spike in short-term rates. If those rates are going up, though, a bank-loan portfolio's income stream rises right along with them.

Everything Has a Price
Of course, there's no free lunch. The trade-off for that attractive interest-rate profile and generous income potential is a healthy dose of credit risk. That's because portfolios in this category invest almost exclusively in yield-rich debt that falls under the rubric of highly leveraged loans. (In this case, leverage refers to issuer balance sheets, rather than fund-portfolio leverage.)

Historically, much of this bank-loan debt was incurred as a result of merger and acquisition activity or in the service of capital-intensive business models. Such deals typically involve heavy debt loads, but also the kind of hard-asset security or cash-flow stability that lenders look for to underpin the senior, secured, first-lien structures that dominate this market. There are still plenty of such loans in the marketplace, but much of the issuance in recent years has been the product of large-company, private-equity LBO deals that were in vogue prior to the financial crisis. With the exception of a couple years in the mid 1990s, for example, loans totaling more than $1 billion in size generally didn't exist in this market prior to the late 1990s. They took off thereafter, however, peaked at roughly 50% of the universe during the precrisis boom years, and still comprise more than 40% of the market today according to data from Credit Suisse.

It's also critical to know what kind of fund you're looking at. Bank-loan portfolios come in multiple structures, all the way from exchange-traded closed-end funds, to interval funds that only allow you to request a share tender once per quarter or once per month (like a redemption, but there's no guarantee you'll get all you ask for back at one time), to plain-vanilla open-end mutual funds--and many of them can use portfolio leverage, which is analogous to margin borrowing. That variety is a concession to the fact that loans are not actually securities, and many still don't trade very often or easily (i.e. they can be illiquid). Whereas a leveraged, closed-end bank-loan fund can take on significant issuer size and credit risk, for example, without worrying that redemptions will cause a cash crunch, managers of open-end bank-loan funds typically stick with the largest, most liquid, higher-tier loans and usually keep plenty of cash on hand in case investors come calling for their money.

Is it Safe to go in the Water?
What does all that say about the safety of the bank-loan market? Company size is often considered a positive indicator when it comes to the avoidance of bankruptcy, so there's a case to be made that the universe as a whole has a safer flavor than it once did, particularly now that the financial crisis has passed. Meanwhile, there's a sense among many managers who run bank-loan and high-yield bond portfolios that a diminishing default rate and expectations of a fairly healthy--if sluggish--economy going forward argue that risk is generally dissipating rather than gathering, even given the market's May 2010 volatility.

When it comes to bank loans, in particular, though, everything ultimately comes down to price. Bank-loan managers are keenly aware of how much they're willing to pay for loans, how much they figure to receive in the event of a default that goes all the way through to bankruptcy and/or liquidation, and how much income shareholders are likely to receive in compensation for those risks.

Things look good on those fronts--today. The average loan in Barclays Capital's U.S. High Yield Loan Index is priced around 90 cents on the dollar, which would theoretically leave some room for capital appreciation even if leveraged-loan defaults remain steadily in the roughly 5% range at which they currently reside. The market also appears to have supply dynamics in its favor: Numerous issuers have elected to lock in low borrowing costs by issuing fixed-rate high-yield bonds, in turn paying down bank-loan debt. Estimates vary of how much the market has shrunk, but the numbers appear to be at least $100 billion and more than 15% of principal value outstanding over the past couple of years. Perhaps not as meaningful in a flat market, that supply contraction could prove much more critical if and when investors do eventually begin flocking into loans more aggressively. And while the average income payout among bank loans may look a bit paltry at between 3 and 3.5 percentage points over three-month LIBOR (currently only around 0.5%), that margin is as high as it's been in the past several years. Meanwhile, many new loans are structured with so-called floors to keep payments generous even when LIBOR is low.

Investor, Know Thyself
The trick, of course, is knowing whether that's enough comfort, and whether it makes sense to move money into bank-loan funds at all. The second question is easier than the first. Only investors who would otherwise be comfortable holding a high-yield (junk-bond) fund ought to give bank loans consideration. The latter have additional structural strength, and should prove more secure over full market cycles, but they definitely court risk, as investors learned during the 2008 sell-off. As a result, bank-loan funds are a reasonable complement to the core of a bond portfolio, but probably not a suitable replacement.

Whether bank loans offer sufficient value today ultimately depends on whether the U.S. economy is sluggish, remains stable, or improves. Bank loans should perform well in any of those scenarios, but would be at meaningful risk of market volatility and capital losses if we experience a double-dip recession. For investors who aren't especially worried about that eventuality, a bank-loan portfolio might make good sense, but sooner rather than later. If the economy continues to strengthen, the Fed hikes short-term rates, and investors begin flocking to bank loans, the cushion of value and security they appear to offer today won't be there when their prices go up.

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Eric Jacobson does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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