U.S. Markets closed

In Search for Yield, Interest Rises for Bank Loan Funds

Richard Satran

The Federal Reserve is not ready to move yet, but when it does raise interest rates, bank loan funds will be one of just a handful of investments that are "well-positioned to participate in rising rates," says Jeff Bakalar, who heads ING's loan funds unit that includes the flagship ING Senior Income Fund.

Nearly everyone expects rates to rise, and many investors are shifting positions already, he says. The markets showed how jittery they are over a possible halt in the Fed's easy-money policy this week when a mere mention that the economy is "improving quite a lot" by a Fed official ended a rally in stocks and bonds, pushing them into negative territory. The dollar continued on its recent upturn.

The markets were rattled even though the Fed's Chicago regional bank president, Charles Evans, assured his audience in a speech that no move is imminent. It showed that even a small twist of Fed policy could contort the whole investing landscape. A bigger move - a tightening after five years of easing - could totally reshape it. Chairman Ben Bernanke told Congress Wednesday that the economy is stronger but still needs the help of Fed bond purchases to keep rates low. Few expect any big policy move, yet.

"When it happens, its impact may fall outside of expectations," Bakalar says. "Many investors may not be prepared for the speed and magnitude of the move."

[Read: Pimco's El-Erian Explains Why Zombies Threaten the Markets.]

He says it could take a year or more for the Fed to act, but when it does, investors remain so heavily invested in the fixed-income sector that many portfolios could take a hit. Individual bond holdings remain high by historic standards, even after this year's rush to equity. Balanced funds and target-date funds, among the most widely held by individuals, often include high percentages of fixed income, typically 40 percent to 50 percent for those nearing retirement.

Loan funds in demand. Investors are chasing yield wherever they can get it, of course, but bank loans have the added attraction of promising higher yields and holding their value, unlike highly rated bonds, which will lose value when the Fed changes course.

Investors have been piling into bank loan funds like the ING Senior Income Fund at unprecedented rates this year as people start to look for income alternatives outside the more vulnerable fixed-income sector. That's because bank loan funds run counter to the bond market. They are made up entirely of loans whose payments are pegged to bank loan rates, usually LIBOR (the London interbank borrowing rate). The loans that the funds invest in are not backed by the banks, but are packaged and sold to the funds. They are tied mostly to mergers and acquisitions, particularly private equity deals, and are considered speculative or below investment grade. Because of this, loan funds like the ones Bakalar's Senior Income Fund invests in are one of the few asset classes that benefit when rates rise in an expanding economy. Lipper reports that more than $20 billion have been added to floating-rate bank loan funds this year already, more than is invested in a typical year for the little-known sector. Morningstar data shows that over the past year, loan funds have paid returns of between 8 percent and 18 percent.

The floating-rate bank funds could provide an alternative for investors who have fled to the "safety" of equities as a way to avoid bond market losses if the Fed raises rates. The stock market, too, could be vulnerable to downturns if interest rates increase too suddenly. The expected return rates for stocks - as measured by price-to-earnings - tend to reflect any rise in prevailing interest rates. That will put pressure on stock prices as rates rise - at least until corporate profits rise enough to offset rising rates.

Difficult period ahead. "This will be a very, very difficult period for investors," Bakalar says. "It could happen very quickly and be a very hard landing [when the Fed hikes rates.]" Bakalar concedes that the bank loan sector is not immune to market turmoil. Because loan funds are made up of below-investment-grade loans and some of them employ significant amounts of leverage to boost yields, any worries about overall creditworthiness can cause prices to fall precipitously.

[Read: Why Dividend Stock Funds Keep Growing.]

"This is not a risk-free asset class. It's not just a turbo-charged money market [fund]," Bakalar says. Because the loans are unrated and not considered investment-grade, the sector is susceptible to overall credit concerns. By comparison, money market funds invest only in the high-rated, short-term bank debt and guarantee the principle, or the value of each dollar invested, but pay virtually no yield.

Closed-end funds can borrow up to 33 percent of a fund's assets to boost yield in leverage strategies such as borrowing at a low rate and reinvesting at a higher one. During the financial crisis and the credit freeze, the Senior Income Fund lost about one-third of its value amid concerns over this leverage. In 2011 when the Congressional budget stalemate threatened to shut down the U.S. government's funding, the fund lost about 10 percent of its net asset value in a few weeks, before recovering to gain steadily since.

"It's only during exceptional times like a credit crisis that it happens. It requires a very unusual period of systemic financial risk and concerns about the frailty of bank loans and a massive amount of deleveraging when the babies are thrown out with bath water," Bakalar says. In fact, he adds, the leveraged loan market bounced back strongly, and "you would be well ahead if you had held on to the fund."

The biggest problem now for bank loan funds is that the huge demand for relatively low-risk floating rate issues is not being met with a lot of new supply from borrowers, which could put a lid on the interest rates paid by funds. "Deals are picking up a bit, but it's still not what we would hope," Bakalar says. The demand from issuers wanting to do deals could pick up in a stronger economy, restoring higher yields, he adds.

Todd Rosenbluth, director of ETF research at S&P Capital IQ, says exchange-traded funds have been entering the space amid concerns that the growth in the loan funds could lead to a lowering of credit quality. "Without a rating, it's hard to know the level of risk that's tied to some of these funds," Rosenbluth says.

But he says the overall attractiveness of loan funds right now comes from their ability to pay higher rates as the Fed tightens. "The risk in any individual loan can be partially offset with a large number of them that a fund owns," Rosenbluth says. Because they are classified as bank loans, they are among the first liabilities to be paid off after a default. "They they have a higher level of security than other debt classes like junk bonds, so they are more likely to pay off," Rosenbluth says.

[See Digital Utilities That Pay: Here Are 10 You Use Every Day.]

Indeed, when junk bond yields sank below the level of leveraged loan funds, it set off a buying frenzy, since the loan funds now offer higher yields with less risk than bonds.

Bakalar says loan funds are "a market where fund managers can really protect you from the downside." His fund charges a relatively high annual fee of 1.6 percent, but it goes toward a management staff of 25 credit specialists who assess the risk of each issue.

Bank loans have a relatively low historic default rate of a bit over 3 percent, which is lower than unsecured or other subordinated debt. Just as important, Bakalar's ING bank-loan credit team focuses on recovering assets if there is a default. The bank loan fund generally manages to recover 70 cents to 80 cents on the dollar, more than twice the overall recovery rate for junk bonds. "Most of [the ING credit team has] been working together for 12 years," Bakalar says. That's long enough to have been tested by hard times. Since 2008, the Senior Income Fund has jumped from an average to an above-average rating by Morningstar, which now gives it a four-star rating for its 8.5 percent annualized return over the past three years, more than twice its bond benchmark. That experience could help in good times ahead if rates rise as Bakalar expects.

More From US News & World Report