Investors Prepare For Rate Hike With These Funds

New York (Reuters) – Bank-loan funds that aim to pay investors more when interest rates increase are having their best fundraising streak in more than two years as buyers chase performance and the fulsome prices the investments now command.

The products, which are sold as mutual funds and exchange-traded funds such as the iShares Floating Rate Bond ETF (FLOT) and the SPDR Barclays Investment Grade Floating Rate ETF (FLRN), purchase floating-rate loans that will pay out more in interest if the key benchmark London interbank offered rate (Libor) crosses above the 1% mark. Three-month Libor is currently 0.89%.

Investors are eyeing the December U.S. Federal Reserve monetary policy decision with increased anticipation, as the central bank is widely expected to raise rates. Such a move could push Libor over that threshold, triggering floating-rate borrowers to boost their payouts.

Investors look to Libor to understand short-term corporate borrowing costs.

Typical Bonds Do Not Adjust Payouts

By contrast, a typical bond will not adjust what it pays out even as other interest rates in the market rise.

"This is a tried-and-true asset class for performance in a rising-rate environment," said Eaton Vance Corp institutional portfolio manager Christopher Remington. "Investors are getting ready." Nearly two-thirds of the S&P/LSTA Leveraged Loan Index's holdings are structured to pay more interest as soon as Libor rises above a 1% "floor," according to S&P Dow Jones Indices.

Three-month Libor has surged 43% since late June to seven-year highs, with a good portion of the increase tied to new regulations governing the pricing of money-market funds, easily traded investments generally considered as safe as a bank deposit.

The regulations forced money market funds that invest in corporate debt to let their share prices float with the market and possibly impose redemption fees in times of market stress.

In turn, those changes drove cash away from those funds, pushing borrowing costs higher for companies that depend on money markets.

Steady Stream Of Inflows

Floating-rate loan funds tracked by Lipper's loan-participation fund category have pulled in money in each of the last 12 weeks, their best streak by that measure since April 2014. That amounts to $3.9 billion in new cash since July, according to the Thomson Reuters research service.

The current streak pales in comparison to the 95-consecutive weeks of net inflows recorded by the funds from 2012 to 2014, according to Lipper.

The average U.S. bank-loan mutual fund investor earned just 2.8% a year over the last five years, according to a Morningstar estimate, based on data showing when investors moved cash out of the fund. Investors would have gained 4.7% had they bought and held the fund over the entire period, the research service said.

Now investors are coming back, with values harder to find. And 62% of the S&P/LSTA U.S. Leveraged Loan 100 Index's loans are trading at or above their face value, according to S&P. Many borrowers are now tying their loans to lower one-month Libor rates to delay hitting the 1% threshold that would trigger raising their payments.

"If expectations are for high single-digit or double-digit returns, that very likely will not be achieved," said Remington.