Bank loan funds: best in good times

Bank loan funds offer high yields and protection against rising interest rates. Anything else you should know about them?

Well, yes. The average credit rating on bank loan funds is B or BB, squarely in the high-yield category. And like high-yield bonds, the ability to buy or sell securitized bank loans is great – until it isn’t. If you’re picking a bank loan fund for your clients, you need to be mindful of what can happen in a worst-case scenario, and what your manager should be doing to protect shareholders.

Bank loans have been selling like eggs for Easter the past 12 months, drawing in $22.5 billion in net new cash. The funds have about $120 billion in assets. Bank loan ETFs have another $12.5 billion.

Bank loan funds buy securitized packages of loans, rather than individual loans. The securities usually have higher standing in bankruptcy court than bonds, which offers a bit of comfort when there’s a default. The average open-ended bank loan fund yields 4.21%, versus 2.23% for the 10-year Treasury note, while the five ETF bank loan funds yield an average 4%.

“Bank loan default rates tend to be lower than junk-bond default rates,” said John Lonski, chief economist for Moody’s Capital Markets Research Group in an e-mail. The long-term average high-yield default rates are 3.3% for loans and 4.8% for bonds. The long-term median (half higher, half lower) high-yield default rates are 2.5% for loans and 3.1% for bonds.

The most recent high-yield loan default rate peak was 4.0% in June 2016, versus 8.3% for high-yield bonds in January 2017. The all-time high for bank loans: 12.2% for bank loans in Nov. 2009 and 16.6% for high-yield bonds. During the 2001 recession, bank loans had a peak default rate of 7.7% versus 12.2% for high-yield bonds.

Those long-term average default rates for bank loans, however, might be due for a rise. “The current recovery’s relaxation of high-yield bank loan covenants warns of higher than otherwise default rates for HY loans during the next extended bout of systemic financial stress,” Mr. Lonski said.

No one is predicting a financial crisis this year – although, to be fair, very few people were predicting a financial crisis in 2008, either. The average bank-loan fund fell 29% in 2008, including reinvested interest. What should you check in a client’s bank loan fund?

• Diversification. As with junk funds, owning many issues is better than owning a few, even though concentration can result in a short-term performance boost.

• Cash. Bank loans are liquid, but all high-yield securities tend to be less liquid in times of distress. Look for funds with a healthy cash position that they can use in times of stress. Otherwise, they could have to sell their most liquid holdings in a crisis, leaving the worst to languish in the portfolio.

• Liquidity. Some funds have loan facilities to draw upon in the case of a rush to the exits. That’s a plus, but not if the fund skimps on cash reserves.