With interest rates so low, individual investors have been piling into bank-loan funds, taking on more risk as they seek higher yields and a hedge against inflation. In April $729 million flowed into U.S. mutual funds that invest in the corporate debt, also known as floating-rate loans, according to preliminary data from EPFR Global, a research firm. This year investors added a net $1 billion to the funds through May 2, after pouring in $6.4 billion last year.
The funds buy speculative-grade loans used to finance buyouts. Because their rates are variable, the loans are less vulnerable than fixed-rate investments to increases in interest rates. And they usually offer better yields than high-quality bonds. “Where else can you get 4 percent to 5 percent with zero duration?” says Christopher Remington, institutional portfolio manager for Eaton Vance, which oversees about $24.7 billion in floating-rate loans for individual and institutional investors. Duration is a measure of interest-rate sensitivity.
For Maury Fertig, chief investment officer of money manager Relative Value Partners, bank loans are “a sweet spot right now.” The loans have a chance to gain value as the economic recovery continues, he says, “and in the event of higher rates, I’m not going to lose a tremendous amount of principal.” Bank loans account for about 15 percent of his clients’ fixed-income assets.
The advantages come with significant risks. In times of economic stress, the funds can perform worse than junk bonds. Bank-loan mutual funds lost about 30 percent during 2008, compared with about a 26 percent decline for funds that invested in high-yield bonds, according to data from Morningstar. “People are so starved for current yield that I think it’s pushing them into spots they otherwise wouldn’t go,” says Mark Balasa, chief investment officer of Balasa Dinverno Foltz, a wealth management firm. “In 2008 these things got shelled.”
The Financial Industry Regulatory Authority in July issued an alert warning investors about purchasing complex products, including floating-rate loan funds. “Funds that invest in floating-rate loans may be marketed as products that are less vulnerable to interest-rate fluctuations and offer inflation protection, when in fact the underlying loans held in the fund are subject to significant credit, valuation, and liquidity risk,” Finra stated.
Investors may not realize that floating-rate loans tend to move more in step with stocks than they do with bonds, says Douglas Anderson, a director with Harris MyCFO, a unit of Bank of Montreal. “The more you take out of traditional high-quality fixed income, the more exposure you’ll have in the event of a significant market correction,” he says.
Another risk investors may overlook: Buyout firms’ practice of piling debt on to companies they own to extract payouts may reduce the creditworthiness of borrowers and make defaults more likely. SeaWorld Parks & Entertainment, the Orlando-based amusement park operator and home of Shamu, the killer whale, was downgraded by Standard & Poor’s after getting a $500 million loan in March to fund a dividend to owner Blackstone Group. S&P lowered SeaWorld’s credit rating to B+, four levels below investment grade, from BB-, because of the increase in leverage following the distribution. “When everyone is concerned about yield and return and growth, rather than risk,” says Joseph Duran, chief executive officer of investment adviser United Capital, “it invariably leads to bad outcomes.”