It’s not easy these days to find an investment offering a decent yield and protection from losses caused by rising interest rates.
Hence the soaring popularity of mutual funds that buy adjustable-rate corporate debt.
Known as bank-loan or floating-rate funds, the group has posted two years of strong returns, which have continued in 2011. Its 2% average gain in the first quarter was second-highest among bond-fund categories, trailing only a 3.7% average total return notched by junk-bond portfolios, according to fund tracker Lipper.
Plus, unlike most bond funds, floating-rate funds won’t decline in value if interest rates rise, which they are widely expected to do as the economy picks up steam.
But floating-rate funds are far from conservative. They invest in “junk"-rated bank loans made to companies with low credit ratings. Proceeds often are used for leveraged buyouts that can leave a company — the borrower — in a precarious financial condition. If the economy falters, bank loans could tumble in value.
“This is not a money-market fund with a little bit of kick. This really is like a high-yield fund,” said Sarah Bush, an analyst at Morningstar Inc. “That’s not to say these funds don’t hold some attraction, but you have to be aware that there’s a lot of credit risk embedded in them.”
That risk became real in 2008, when floating-rate funds plunged an unprecedented 27%, though they recovered those losses in 2009 and surged 9.4% last year.
Fund managers say the concerns are overblown.
“If you expect continued growth in the economy, that is a great environment for these companies to be able to continue to grow and improve from a credit-quality standpoint” so they can pay off their loans, said Zane Brown, fixed-income strategist at Lord, Abbett & Co.
The sheer popularity of bank-loan funds, however, should give pause to people who feel it’s safer to avoid the latest red-hot area.
Investors poured a net $18.6 billion into floating-rate funds last year, followed by $13.5 billion in the first quarter, according to Lipper. That pushed assets up to $54 billion at the end of March, from $12.1 billion at the end of 2008.
After taking in so much money, the funds could be vulnerable if sentiment turns and fickle investors dart for the exits.
After years of dependable returns in which loans rarely traded at less than 90 cents on the dollar and usually much more than that, average loan values skidded to 62 cents at the height of the financial crisis in late 2008, according to Standard & Poor’s.
They staged a sharp recovery in 2009 — hence, a 41% average fund return that year — and were up to 96 cents by the end of March.
Fund managers, however, say bank loans remain attractive by historical standards.
Interest rates on floating-rate loans are pegged to a benchmark, with borrowers typically paying the London Interbank Offered Rate plus a specified percentage known as a spread.
Spreads have narrowed from a range of 5% to 7% during the market blowup to a range of 3.5% to 4.5% now, said Scott Page, a floating-rate manager at Eaton Vance. For years before the financial crisis, the spreads averaged about 2.75%, and the loans were considered “a perfectly fine product,” he said.
“We are being paid handsomely for the credit risk we take,” Page said. “We’re not being paid the outrageous amounts we were being paid nine months ago [but] we still think it’s attractive.”
Spreads falling near 2% would signal potential trouble, Page said.
Aside from prices and interest rates, some experts warn about the return of so-called “covenant-lite” loans that were popular in the easy-money years before the crisis. Such borrower-friendly loans, issued with limited provisions to help creditors recoup their money in a default, surged to 25% of bank loans issued in February before falling to a still-high 18% in March, according to S&P.
A danger for investors is that a fund manager will focus on riskier holdings to keep returns high. Bush advises checking the credit ratings of a fund’s holdings.
Most such funds are concentrated in loans rated single-B and double-B, she said. Large holdings of lower-rated debt, such as triple-C, could indicate a fund that’s taking outsized risk.
A related indicator is the percentage of holdings in unrated securities, which could be hard to sell if the floating-rate market weakens, leading to poor returns. Some funds hold few unrated securities, while others have as much as 13% to 15%, Bush said.
Another red flag is leverage, which can boost returns in good markets but amplify losses in bad ones.
Finally, look to see whether the manager has a long track record in floating rate and whether the fund company has a large research department to do the labor-intensive work of scrubbing funds.
Investors should also be aware that floating-rate funds may not benefit indefinitely from rising rates. The loans typically are “callable,” meaning borrowers can pay them off when it makes sense to do so.
“If you’ve got a really nice, juicy yield on a company that was troubled when you bought it but whose fortunes have turned around, the upside is going to be limited because the bond is going to go away at some point,” Bush said.