What’s an income-hungry investor to do? Among taxable bond fund categories tracked by Morningstar Inc., just six are in positive territory for the year. Four were up only 1.32% or less going into Thursday.
The other two, bank-loan and high-yield funds, sport average total returns of 5% or better plus yields of 3.5% or better as of Oct. 31.
And forget about municipal bond funds. Not a single muni category had a positive year-to-date return going into Thursday.
Though similar in performance this year, bank loan and high-yield funds differ in holdings and how they respond to market conditions.
Bank loan funds invest in debt that has floating interest rates. Their rates typically get reset every 30 to 90 days. The bulk of high-yield funds hold fixed-rate bonds that mature several years out.
So when interest rates in the broad market rise, floating-rate loans’ prices do not get clobbered the way fixed-rate bonds do.
Credit Suisse Floating Rate High Income Fund , the top-performing bank loan fund of the past five years, had its worse quarterly decline in nearly five years in Q3 2011, when it fell 2.56%. The top high-yield fund, Fidelity Advisor High Income Advantage , fell 11.08% in the same quarter.
Bank loan funds’ popularity has jumped. Assets in loan participation funds tracked by Lipper Inc. nearly doubled to $135.88 billion as of Oct. 31 from $68 billion a year earlier. That was the biggest increase among Lipper bond groups and far exceeded the 5% hike in high-yield fund assets to $302.79 billion from $288.74 billion.
Floating-rate loans commonly have less credit risk than high-yield bonds. That’s because the loans are senior secured debt, at the top of the capital structure. Holders of such debt have first claim on a company’s assets in the event it collapses.
For those reasons, senior secured debt is good at protecting investors from rising rates, says Scott Baskind, co-chief investment officer of the bank-loan team at Invesco.
“Investors are more concerned with rate risk than credit risk now,” Baskind said. “As a result, they want to shorten the duration of their fixed-income holdings.” By resetting its interest, floating-rate debt keeps a short duration.
Still, floating-rate loans do have credit risk. They are not investment-grade debt. “Some people think loan funds are like money market funds,” Baskin said. “They are not. They have credit risk.”
Mixing It Up
Some bank loan funds include high-yield debt in their portfolios. When shopping for a bank loan fund, check the weighting of corporate bonds in a portfolio. That can lengthen a fund’s duration.
The flip side is true too. John Hancock High Yield Fund had 6.9% of its money in preferreds, 5.5% in bank loans and 1.25% in asset-backed debt as of Sept. 30.
“Floating-rate debt gets us to the top of the capital structure, while reducing our rate sensitivity,” said manager Dennis McCafferty. “It’s a good diversification benefit.”
High-yield funds outperform bank loan funds over time. But they are more volatile than bank loan funds, McCafferty says.
And once the Federal Reserve starts to raise rates? Rising rates signal improving economic strength, which cuts default risk for high-yield funds, McCafferty adds.
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Bank Loan Funds’ Key Traits: Income With Low Rate Sensitivity – Investor’s Business Daily
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