A Bumpier Ride For Bank Loan Funds
For most of the past decade, bank-loan, or "prime rate," funds have been sweet deals for income-oriented investors. The funds buy slices of floating-rate loans that banks make to noninvestment-grade corporate borrowers. The interest rates on these "leveraged loans" average 3.5 percentage points above the London Interbank Offered Rate (LIBOR), a key bank-to-bank lending rate, and are reset every three to six months. As a result, investors in these funds have managed to pick up bond-like yields with minimal fluctuation in the net asset value (NAV) of their funds.
Now, defaults on bank loans are rising, and credit quality throughout the economy is deteriorating. The Securities & Exchange Commission is putting pressure on bank-loan funds to change the method of valuing their portfolios. That will lead to wider price swings. "How you're pricing loans is having a bigger impact on performance, because there are more bad loans out there," says Morningstar analyst Sarah Bush.
Given the market, bank-loan funds are having a so-so year (table, page 212E8). The yields are high--8.2% on average--because short-term interest rates are high. But NAVs are in a slight decline, so total returns are on average 3.9%. That's still better than most junk-bond funds.
A bad bank loan isn't quite as bad as, say, a junk bond that fails to make its interest payments. The loans these funds buy are senior, meaning the debt must be paid ahead of others, and are secured by assets or other collateral. Junk bonds are usually unsecured IOUs and subordinate to bank loans. Even in default, the recovery rate on these loans is about 75 cents to 80 cents on the dollar, about twice the recovery rate of junk bonds.
In the past, bank loans were a private affair, worked out between the bank and its client, then carried on the bank's books at face value and held until maturity. But increasingly, lenders have been selling off pieces of the loans to mutual funds and other institutional investors, and a secondary market has evolved. Trading in the secondary-loan market grew from $20.8 billion in 1994 to $110.3 billion in 1999, according to Loan Pricing Corp.
Despite price fluctuations on the secondary market, many funds were still valuing most of their loans at face value until the SEC issued an interpretive letter last December ordering them to change their valuation methodology. Loans that trade in the secondary market must now be priced as they trade, or "marked to market," like stocks and bonds. If a reliable market quote is unavailable, managers must estimate the "fair value" of the asset as if it were sold today.
The oldest of the bank-loan funds are most wed to the old valuation system and have been under the most pressure to change: Morgan Stanley Dean Witter Prime Income Trust, Eaton Vance Prime Rate Reserves, and Van Kampen Prime Rate Income. Morgan Stanley's fund now prices 44% of its loans by the market, according to its latest semiannual report. Up until a year ago, none of the loans was marked to market. Eaton Vance now prices 70% in the market, up from 10% this March. Van Kampen declined to disclose to what extent it is using market prices in calculating NAV.
Longtime owners of those funds are now experiencing more volatility in NAVs. "For a long time, the funds would move just pennies a year," says Bush. No more. In nine of the past 10 years, Eaton Vance Prime Rate Reserves never lost more than 0.4% of NAV. This year its NAV is down 2.3% as of Oct. 18. Van Kampen Prime Rate Income had not lost more than 0.5% since 1989, until it started marking to market last year. Its NAV fell 2.3% in 1999 and 4.1% this year.
NO SURPRISES. Some of the volatility comes just from the change in pricing. But bigger forces are at work. Last year, leveraged loan defaults rose to 1.94%, the highest level since 1992. Loan Pricing analyst Michael Lavin says the defaults so far this year suggest that 2000 default rates will be "on par with or exceed those seen in 1999."
Not all funds need to change to marked-to-market. Newer portfolios, such as AIM Floating Rate and Franklin Floating Rate, have used market prices for daily valuations since their inceptions. Investors in those portfolios should not be getting any unusual surprises.
Investor interest in bank-loan funds is growing. In August, Fidelity Investments launched its first in this category: Fidelity Advisor Floating Rate High Income. The Fidelity offering is also the first of its kind to allow daily redemptions. Eaton Vance, which pioneered these funds, came out with a daily redemption fund in September. Prior to these new entries, most funds allowed investors to redeem shares just once per quarter.
Even with their greater volatility and credit risk, bank-loan funds can make sense. Since they behave neither like the stock nor bond market and have a relatively high yield, they make good diversifiers for any portfolio.