Bank loan funds and ETFs do have adjusting rates, but their lower-quality holdings pose real risks.
When interest rates are low, some investors stretch for yield by taking on credit risk. At the same time, many investors are also seeking alternative ways to protect themselves against a potential rise in interest rates, without sacrificing that hard-earned yield.
These dual concerns have led many to consider bank loan funds, which recently have had more inflows than any other domestic fixed-income asset class.
Other Than Recent Returns, What Makes Bank Loan Funds So Popular?
Bank loans, a type of corporate debt, have a maturity date and pay interest. Their interest payments, however, are determined based on a floating reference rate (typically Libor) plus a fixed spread. Depending on the loan agreement, the rate is adjusted periodically, typically at intervals of 30, 60 or 90 days.
Floating-rate notes exhibit minimal price sensitivity to changes in interest levels because their coupon varies with market interest rates. Bank loans—because they are secured by a pledge of the issuer's assets—are senior to most other corporate debt.
That means that in the event of a default, they would get paid before the issuer's traditional corporate bonds. This can lead to higher post-default recovery rates.
Floating-rate loans most commonly serve as an alternative source of financing for companies whose credit quality is rated below investment grade. Even though the loans are "secured," the default rate of bank loans tends to be similar to subinvestment-grade bonds.
Unfortunately, credit risk tends to appear at exactly the wrong time, when equities are performing poorly. In other words, just when you need the bonds in your portfolio to provide shelter from the storm, the risks inherent in corporate loans show up, and both stock and bond holdings are hit simultaneously.
This is exactly what happened in 2008, when floating-rate funds averaged losses of 29 percent, underperforming the Barclays Capital Aggregate Bond Index by 34 percentage points.
A Peek Under the Hood
Floating-rate funds purchase corporate loans from banks. Keep in mind that the companies with the strongest credit don't need to go to banks. They typically get their funding directly from the capital markets.
Recall that the borrowers in floating-rate funds tend to be companies below investment grade. Again, this means that, even though the investment is not an equity investment, it will have a significant amount of equitylike risk.
Let's take a look at a few potential investment options in this space. First, we'll review the bank loan mutual fund with the highest assets under management, the Oppenheimer Senior Floating Rate (OOSYX) fund. The institutional share class carries an expense ratio of 0.86 percent, and the fund, across all share classes, manages $20.7 billion. (By comparison, the biggest bank-loan ETF is the PowerShares Senior Loan Portfolio (BKLN | B).)
The Oppenheimer fund takes a significant amount of credit risk. BBB is the lowest investment grade. The percentage allocation to issuers grouped by credit rating is: