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When the first bank-loan mutual funds came out, they
were interval funds in which investors could only
add or subtract money at month- or quarter-end. Bank
loans don’t have the liquidity of standard corporate
debt, so fund companies wanted to ensure that flows
could be handled in an orderly fashion.
But fund investors love the daily liquidity of mutual
funds. Even if they hold their funds for a decade,
investors have peace of mind knowing they can get
out at any time. Thus, it wasn’t surprising that as
the bank-loan market grew, the fund industry slowly
moved to daily liquidity funds. Fidelity was the
first, and its answer to the liquidity challenge was
to hold a sizable cash stake and ensure that some
of the bank-loan portfolio was of the most liquid
issues. That meant sacrificing some returns, but it
seemed a practical solution.
Gradually the industry followed Fidelity’s lead in
moving to daily liquidity, though many of the next
generation of bank-loan funds were less cautious
about building a cash hoard for rainy days. As people
worried about rising interest rates, the appeal
of a bond class in which yields were adjusted to
interest-rate shifts grew. The category grew from
$8
billion in
2003
to
$12
billion in
2008
and then all
the way to
$138
billion at the end of
2013
.
That brings us to the challenge facing bank-loan funds
today. They were still a tiny part of the bank-loan
market in the
2008
–
09
recession. Now they are quite
big, though there are other big owners of bank loans
outside the mutual fund world, and we really don’t
know how the funds and fund investors will behave
in the next recession. In addition, there’s a potential
for disappointment when rates do rise. Bank-loan
yields are pegged to Libor, a short-term rate, so they
don’t respond to increases in long-term bond yields.
Because many bank loans have Libor floors, investors
won’t see an increase in yields on many loans until
short-term yields rise by more than
75
basis points.
Thus, there will be a lag that may surprise investors
who thought they were getting greater protection
against rising rates than they are.
We’ve already gotten a whiff of the challenges ahead,
however. Flows into bank-loan funds have become
pretty erratic. In
2014
, three funds had a single month
in which more than
$1
billion net left the funds. Two
of them had to tap a line of credit to ensure a smooth
exit for shareholders, though they report they only
needed it for a couple of weeks. I have no problem
with tapping lines of credit—that’s the point of
having them. But this does illustrate the challenges of
managing a limited-liquidity asset class in a daily
liquidity format.
Ten funds have endured outflows of at least
$1
billion
for the
12
months ended June, and three have seen
more than
$4
billion flow out:
Oppenheimer Senior
Floating Rate
OOSAX
,
Fidelity Advisor Floating
Rate High Income
FFRAX
, and
Eaton Vance Float-
ing Rate
EIBLX
. We have lowered the Morningstar
Analyst Ratings of the Oppenheimer and Eaton Vance
funds to Neutral and Bronze, respectively, because of
the challenges presented by redemptions.
I don’t want to suggest disaster is lurking—only that
we haven’t seen these funds tested by a recession
since they became big. There are some positive
factors here, too. Bank loans are more senior than
high-yield debt and thus should get better recoveries
if the default rate picks up. Most of the big man-
agers of bank loans have experience and depth to
manage redemptions. And despite the redemptions,
the average bank-loan fund is up about
1%
for the
trailing
12
-month period.
Given these challenges, there are a few ways to
respond. Obviously, you can avoid the category
completely, or you can buy a closed-end bank-loan
fund where redemptions are not an issue. How-
ever, they have leverage, so you’re merely exchanging
one kind of risk for another. You can also choose
a fund like Fidelity Advisor Floating Rate High Income
that takes a more conservative approach.
K
Bank-Loan Funds Are Cause for Concern
The Contrarian
|
Russel Kinnel
Our Contrarian Approach
I go against the grain to
find overlooked funds that may
be ready to rally.