Bank loan funds are back: here are 2 to consider

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Bank loan funds lacked appeal for investors in 2019 and 2020 due to falling interest rates. But the economic recovery and the potential for rising short-term interest rates put the category back in the spotlight in 2021. The category’s fourth asset at the start of the year. Demand for high yield bond funds has been more subdued this year despite the similarities between the two asset classes. While high yield bonds have greater upside potential, the defensive characteristics of bank loans make them an attractive portfolio diversification tool. The unique characteristic of variable rate bank loans, their hierarchy in capital structure, and industry makeup of the loan market all provide an attractive relative value opportunity compared to high yield bonds.

Although bank loans offer less yield than junk bonds, they do have some attractive qualities. Coupon payments for bank loans float with Libor every few months, so the loans contain very little interest rate risk. When yields rise, bank loans retain their value, while the prices of fixed rate bonds fall. For this reason, the Morningstar Bank Loans category has outperformed the High Yield Bond category during historical periods of rising rates such as the taper tantrum in 2013 and the interest rate shock in the first half of 2018.

Another attractive feature is the age of bank loans relative to high yield bonds in the capital structure of many corporate issuers. While the average loan and bond default rates have been very similar over the past two decades, the average loan recovery rate was 1.5 times that of bonds. As a result, high yield bonds may suffer more than loans during massive credit sales. During the credit run-off from February 20, 2020 to March 23, 2020, the median fund in the bank loan category fell by 20.4%, while the median fund in the high yield bond category fell by 21. 2%. The bank lending category also outperformed by over 100 basis points when credit markets were liquidated in the fourth quarter of 2018. Admittedly, these performance differences are not significant, and bank loans also underperformed bonds. high yield in times of stress, such as in 2008, when leveraged buyers unwound positions to deal with margin calls. But their seniority in the capital structure should provide additional protection against permanent loss of capital in the event of default, making loans generally preferable to bonds when defaults increase.

In addition, the composition of the bank loan market contains fewer cyclical industries than the high yield bond market. Energy is the largest industry in the high yield bond market and accounted for 13% of the Morningstar US High Yield Bond Index in April 2021, compared to less than 3% for the S & P / LSTA Performing Loan Index. Instead, services, IT, and healthcare made up a larger portion of the bank lending market, leading to less volatile returns over time.

Variable rate of the T. Rowe price (PRFRX), which has a Morningstar Analyst Gold Rating, is one of Morningstar’s Top Picks in the bank lending category. Senior Manager Paul Massaro has led strategy since its inception in 2011 and is supported by a strong credit research team. The team’s strong conviction and selective approach have led to strong risk-adjusted returns since its inception, and the strategy has worked well during both massive sells and strong markets. The team chooses its spots with care; it focuses on BB and B rated loans and is selective among CCC loans, which have generated the lowest total return and highest volatility relative to other credit rating levels over the past 25 years. The team’s selection ability has been demonstrated by its average default rate of 0.1% since its inception, while the bank credit market has an average default rate of 3%.

Massaro and his team have also demonstrated strong liquidity management during times of credit stress and volatile fund flows. Maintaining a liquid portfolio is especially critical for bank lending strategies, as loans take longer to settle and repayments have been especially large when markets sell off. The team typically keeps more than 5% of the portfolio’s assets in cash and holds high yield bonds as a liquidity cushion before loan allocation. A recent concern is the growth of the strategy’s assets in 2021, as bank loans have become popular. A deluge of influx presents challenges in making liquidity work while maintaining high standards, but T. Rowe Price has built a reputation for responsible capacity management by closing funds before asset growth can potentially hamper the process of investing a strategy.

Silver rated Fidelity Variable Rate High Income (FFRHX) is also a solid option. Basic credit research is the hallmark of Fidelity’s bank lending effort. Seasoned managers Eric Mollenhauer and Kevin Nielsen lead the strategy with the backing of a deep supporting cast. Its 22-person analyst team in September 2020 had two bank loan-specific analysts that look at loan issuers only, while the rest of the cohort covers the entire capital structure across all industries. In addition to the usual credit analysis, business management assessment and profit forecasting, the team pays close attention to the structure and covenants of each transaction. The strategy focuses on large companies – in part a necessity due to its size – but that makes it a more predictable and cautious choice among its peers.


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