Bank loans thriving as bond option

PHILADELPHIA — Bank-loan funds are the beneficiary of a bond market that has made investors leery of most fixed-income investments — particularly junk bonds. Compared with junk-bond funds — to which some consider bank-loan funds an attractive alternative — asset flows into bank-loan funds have remained strong. Last year, investors poured $6.66 billion more into bank-loan funds than they took out, while high-yield-bond funds actually saw net outflows of $1.77 billion, according to Lipper Inc. of New York. Tight spreads between corporate bonds and Treasuries make corporate bonds — including those considered junk — unattractive on a risk/reward basis, said Charles Lieberman, strategist and chief economist with Advisors Capital Management LLC in Paramus, N.J. And an inverted yield curve makes Treasuries similarly unattractive, he added. That has made bank-loan funds — which generally invest in floating-rate loans — an attractive alternative, because while spreads have tightened, such funds can seem better on a risk/reward basis, according to industry experts. The loans are “secured,” meaning that unlike junk bonds, they are the most senior source of capital in a borrower’s capital structure, said Joseph Welsh, portfolio manager of the $4 billion Oppenheimer Senior Floating Rate Fund, advised by OppenheimerFunds Inc. of New York. Still, continued interest in bank-loan funds is something of a surprise. Such funds were popular when the Federal Reserve was raising rates, because they generally invest in packages of loans made by banks to distressed companies at variable rates, which means that the yield goes up when rates rise. When the Fed stopped raising interest rates, many assumed the popularity of bank-loan funds would fade. But that hasn’t happened, and as a result, performance has been stronger than expected. Through Feb. 14, the category had a one-year average return of 6.92%, making it the fourth-best-performing fixed-income category, behind multisector-bond funds (7.03%), emerging-markets-bond funds (8.96%) and high-yield-bond funds (10.99%), according to Morningstar Inc. of Chicago. But bank-loan funds have become the second-best-performing fixed-income category year-to-date, with an average performance through Feb. 14 of 1.28%, behind only that of high-yield-bond funds, which had an average return of 2.10%. It’s something Nicholas Spagnoletti, a partner with Macro Consulting Group LLC in Parsippany, N.J., has noticed, and as a result, he hasn’t trimmed his clients’ positions in bank-loan funds. “I agree that just about anything in the bond market is risky, because the spreads are so tight,” he said. And although Richard Schroeder, executive vice president of Schroeder Braxton & Vogt Inc., a financial advisory firm in Amherst, N.Y., hasn’t put any of his clients in bank-loan funds yet, the current bond market has made him at least think about the possibility, he said. “If they insulate you from some of the current risk and offer you more diversification, I’m all for it,” Mr. Schroeder said. Jumping into bank-loan funds couldn’t hurt, Mr. Lieberman said. Although in most cases chasing returns can come back to haunt investors, in this case, it probably won’t come back to “bite them in the end,” he said. Not all advisers, however, are sold on the idea of adding bank-loan funds to their portfolios. “What’s always kept me away from them is a feeling I can’t get my arms around the risk,” said J. Michael Martin, president of Financial Advantage Inc. of Columbia, Md. Although the loans are secured, and loan holders would be first in line to be paid if there were a default, bank-loan funds don’t seem safe to him, given what he perceives as the recent lending practices of banks — their seeming willingness to lend to just about anyone under the sun. Bank-loan-fund managers disagree. They point out that defaults are rare. But they do happen. For example, some bank-loan funds saw losses in 2000 and 2001 when the telecommunications sector went south, and some telecom companies had trouble repaying their debt. That’s an example of why it’s important to consider carefully the philosophy of a bank-loan fund before investing, industry experts said. For example, the $5.02 billion Eaton Vance Floating Rate Fund, advised by Eaton Vance Corp. of Boston, is one that takes a relatively conservative approach to investing. It avoids the lowest-rated bank loans, with the idea that “a teaspoon of return carries a buck of risk,” said Scott Page, co-manager of the fund. That approach has hurt its relative performance. Year-to-date through Feb. 14, the fund had returned 1.18%, placing it in the 58th percentile of its bank-loan fund category. It had a one-year return of 6.84%, placing it in the 31st percentile; an annualized three-year return of 5.10%, placing it in the 56th percentile; and an annualized five-year return of 4.66%, placing it in the 68th percentile, according to Morningstar. But that doesn’t mean investors shouldn’t consider the Eaton Vance fund, according to a report Morningstar did on the fund at the end of last year. “An emphasis on steadiness rather than on short-term victories pervades this fund’s approach,” according to the Dec. 26 report. For investors looking for shelter in a bond market where it appears that the risk may outweigh the reward on many investments, such a fund may make sense, according to the report.