Swedroe: Bank Loan Funds No Free Lunch

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.

Credit Risk

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:

• BBB: 1.97 percent
• BB: 27.61 percent
• B: 64.1 percent
• Below B: 4.54 percent
• Not Rated: 1.78 percent

Given the fund's credit quality, it shouldn't come as a surprise that it lost 29.34 percent in 2008.

So let's take a look at BKLN, the big PowerShares bank loan ETF. The fund carries an expense ratio of 0.65 percent and manages around $7 billion. The ETF also takes a significant amount of credit risk. The percentage allocation to issuers grouped by credit rating is:

• AAA: 7.46 percent
• BBB: 4.32 percent
• BB: 15.46 percent
• B: 65.64 percent
• Below B: 2.96 percent
• Not Rated: 4.16 percent

Liquidity Risk

A recent research note from Moody's shed some light on the illiquidity of bank loans. The piece noted: "Bank loans are not securities, and trade as private transactions in which settlement times typically range from 15 to 25 days. This is due to the physical and private nature of bank loans, which don't offer the ease of transfer and settlement of securities."

Fund managers have three methods to address this illiquidity when fund redemptions occur:

1. Hold a portion of the fund's assets in cash.
2. Hold a portion of the fund's assets in more liquid bonds.
3. Establish credit facilities that can be used as a source of liquidity.

All of these options have drawbacks:

• Option 1 leaves capital un-invested, and neither of the funds examined earlier have a large cash position.
• Option 2 leaves that capital invested, but the amount invested in investment-grade bonds has a lower expected return than the rest of the lower-investment-grade portfolio. It appears BKLN has taken this approach, with close to 7.5 percent of the fund invested in AAA bonds.
• Option 3 involves increasing fund leverage. The Investment Company Act of 1940 limits leverage to 33.3 percent, so this option can only be used in a limited fashion. Also, leverage increases the riskiness of a fund. Both BKLN and OOSYX have the ability to use leverage.

Impact On Portfolio

Finally, we'll take a look at the impact of bank loan funds on a portfolio. We'll again use OOSYX, the largest bank loan mutual fund by assets, for the allocation to bank loans. From its inception in January 2006 through June 2014, OOSYX has returned 4.8 percent per year. Five-year Treasury notes have returned 4.9 percent per year over this same time period. Since this is basically a tie, no harm, no foul, right?

Wrong. Looking at an investment in isolation isn't the right way to analyze its performance. Instead, you should look at how the investment impacts the risk and return of the entire portfolio. With that in mind, we'll examine the impact of adding a bank loan fund to a portfolio for the period since OOSYX's inception in January 2006.

Let's compare four portfolios, each with a 60 percent allocation to the S&P 500 Index.

• Portfolio A will invest its fixed income in five-year Treasurys.
• Portfolio B will allocate its fixed income 30 percent to five-year Treasurys and 10 percent to OOSYX.
• Portfolio C will allocate its fixed income 20 percent to five-year Treasurys and 20 percent to OOSYX.
• Portfolio D will invest its fixed income in OOSYX.

Portfolio A had the highest return and lowest standard deviation of the four portfolios. While the returns of portfolios A, B and C are all very similar, Portfolio A had the highest Sharpe ratio. As the allocation to bank loan funds rose, the Sharpe ratio went down.

In summary, bank loan funds do minimize interest rate sensitivity. However, they should not be used as substitutes for money market accounts or other high-quality, short-term investments. They entail significant credit risk, as well as liquidity risk. They should be viewed as similar to high-yield bond funds.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.