Scott Page, who manages the top- performing bank-loan fund over the past five years, said the debt is still attractive after a two-year rally. Investors pouring record amounts into funds like his should just temper their expectations.
“This is a dull, 4 to 6 percent a year asset class and it probably always will be,” said Page, 51, who runs the $1.5 billion Eaton Vance Floating-Rate Advantage Fund. “Loans aren’t as outrageously attractive as they were a year ago, but they are still pretty attractive.”
Bank-loan funds attracted $5.62 billion net new money in January, a monthly record, according to Chicago-based Morningstar Inc. (MORN), as investors sought protection from the possibility that a stronger economy and accelerating global inflation will force up U.S. interest rates. Unlike bonds, which lose value when rates climb, bank loans have coupon rates that float with short-term interest rates, minimizing declines.
The funds, which buy loans made to companies with non- investment grade credit, gained 9.4 percent in 2010 and 42 percent in 2009, data from Morningstar show, part of a broad rebound in debt markets following the financial crisis. Those returns won’t be matched this year, said Page and other managers, who predict gains more in line with those before the crisis hit.
‘People Get Hurt’
Investor interest in bank loans has grown since long-term interest rates began rising in October, depressing bond prices. The yield on the 10-year Treasury note climbed to 3.46 percent yesterday from 2.6 percent on Oct. 31. Bonds prices have declined 2.2 percent since October, according to the Bank of America Merrill Lynch U.S. Corporate & Government Master Index.
“People can get hurt in bonds,” Page said.
Eaton Vance’s Floating-Rate Advantage Fund returned an average of 5 percent annually in the five years ended Feb. 18, topping all rivals, according to Morningstar data. The fund uses leverage to enhance its returns. A similar Eaton Vance fund that doesn’t employ leverage gained 4.2 percent annually over the same period.
The funds typically buy five- to seven-year loans made to companies with debt rated below Baa3 by Moody’s Investors Service and BBB- by Standard & Poor’s. The loans provide a fixed spread over a benchmark, usually the London interbank offered rate, and reset about every 40 to 50 days. Since 2009, loans have been pegged to benchmarks other than Libor because short- term interest rates have been so low, Page said.
Loans should outperform Treasuries this year, unless the “economy falls back into a double-dip recession,” Jack Ablin, chief investment officer at Chicago-based Harris Private Bank, said in a telephone interview. Ablin, who helps manage $55 billion, said bank loans represent about 5 percent of his fixed- income portfolio.
From 1997 through 2007, bank loans returned about 5 percent a year, Otis Casey, a credit analyst at New York-based Markit Group Ltd., said in an e-mail. The default rate has averaged 3.9 percent, with a 70 percent recovery rate on defaulted loans, according to an April report by Boston-based Eaton Vance.
“These funds are not without risks but if companies are generally cleaning up their balance sheets that risk looks smaller every day,” Jeff Tjornehoj, an analyst with Denver- based Lipper, said in an e-mail.
The billions flowing into the funds are attracting notice. Chicago-based Nuveen Investments Co., Pacific Investment Management Co. of Newport Beach, California, and Newark, New Jersey-based Prudential Financial Inc. (PRU) plan to introduce floating-rate funds this year, according to regulatory filings.
Eaton Vance managed $22.7 billion in bank loans at the end of 2010, Robyn Tice, a spokeswoman, wrote in an e-mail.
The “steady” returns associated with bank loans disappeared in 2008, said Paul Scanlon, 46, manager of the $456 million Putnam Floating Rate Income fund.
The S&P/LSTA U.S. Leveraged Loan 100 Index fell from about 90 cents on the dollar in August 2008 to less than 60 cents four months later, according to data compiled by Bloomberg.
Bank-loan investors, including hedge funds, relied heavily on borrowed money, Scanlon said. When markets froze in 2008, and loan prices fell, those leveraged investors were forced to sell, driving prices even lower. An increase in defaults by companies with too much debt contributed to the decline, Scanlon said.
‘They Got Slaughtered’
“They got slaughtered,” Scanlon said.
In a December 2008 interview with Morningstar, Eaton Vance’s Page said the selling was overdone and that loans represented “a significant opportunity” for investors.
Prices soon rallied as credit markets returned to normal and the U.S. economy recovered. The loan index now stands at 96.42 cents compared with an all-time high of 101.32 in 2005.
Bank-loan investors hoping to take advantage of an increase in short-term interest rates this year may be disappointed. Returns on new loans may shrink because companies have been able to refinance at lower rates, said Craig Russ, co-manager on the Eaton Vance Floating Rate Advantage Fund.
Burger King Holdings Inc., one of the loans his fund owns, borrowed money in October and is already looking to refinace, Russ said. Burger King, based in Miami, paid 4.5 percentage points above a benchmark for its October loan, according to data compiled by Bloomberg. The new loan, Russ said, would be 3 percentage points above a slightly lower benchmark.
Interest rates on new loans have dropped for six straight months to 4.32 percentage points more than benchmarks, according to S&P’s Leveraged Commentary and Data.
Putnam’s Scanlon said loans could return 7 percent this year as an asset class. Jonathan Blau, head of global leveraged finance strategy at Credit Suisse Group AG (CSGN) in New York, looks for gains of 5 percent to 8 percent, he wrote in an e-mail.
Margie Patel, who manages more than $1 billion for Wells Fargo & Co., isn’t putting bank loans into her two mutual funds. High-yield bonds and stocks will both beat loans this year, she said.
“I don’t think loans are going to blow up, but in a market where risk takers will be rewarded, other opportunities are more compelling,” Boston-based Patel said in a telephone interview.
Still, bank loans probably will benefit from an improving economy, said Elizabeth MacLean, portfolio manager of the $3.4 billion Lord Abbett Floating Rate Fund.
“This is an attractive time to be taking credit risk,” she said in a telephone interview.
Three-month U.S. Libor rates will climb to 63 basis points by the fourth quarter, up from 31 basis points today, according to economists surveyed by Bloomberg. A basis point is equal to 0.01 percentage points.
“When short-term rates do rise they will snap up quickly,” John Bell, who manages $2.5 billion in bank loan products at Boston-based Loomis Sayles & Co., said in a telephone interview. Bell did not lay out a timetable for rate increases.
In the leveraged-loan market, the trailing 12-month default rate among U.S. issuers fell to 2.5 percent in January, down from 11.5 percent in January 2010, according to a February report from Moody’s.
“This isn’t rocket science,” said Page, adding he doesn’t predict the growth rate of the U.S. economy or the trajectory of interest rates when selecting investments. “What we want to know is will a given company stay out of trouble and be able to pay us back.”
Risk will creep back into the market as spreads shrink and lower-quality companies seek loans, he said.
“We will see credit excesses some day. It’s human nature,” Page said. Wall Street will always provide people with an opportunity to do stupid stuff.”
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