This Day On The Street
Continue to site
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

Bank-loan funds needn't be a speculative choice

By John Gerard Lewis


There has been something of a mania surrounding bank-loan funds in recent months. They enjoyed $54.3 billion of year-to-date net inflows through October, as investors increasingly (and desperately) have been seeking yield with interest-rate protection.

But there’s also been the predictable and reflexive pushback by critics whose cautions are largely reasonable, but sometimes overstated.

The money pouring into these products is an understandable phenomenon. Infinitesimal fixed-income yields spur people to go further out on the yield curve and deeper down into credit quality. But the former tactic is beset with interest-rate risk, since bond prices have an inverse relationship with rates. Therefore as rates rise, the value of bonds declines — and the longer the maturity, the greater the magnitude of this reaction.

The latter practice, taking on higher credit risk — which characterizes bank-loan funds — is in the opinion of some commentators even more dangerous. In an article at that carried the over-the-top headline, “The Bond Market’s Ticking Time Bomb,” one adviser recently declared: “Interest-rate risk, you lose the opportunity cost of yield; credit-rate risk, you lose everything.”

Well, okay, but that’s only if high-credit-risk securities were to constitute “everything” in your portfolio. How about a little balance here? It doesn’t have to be “either/or.” After all, no reasonable portfolio allocation would be overweight high credit risk, just as it wouldn’t be overweight high interest-rate risk.

In other words, there may well be a place for bank-loan funds in many individual portfolios, especially as we prepare for rising rates.

Yes, bank-loan funds are marked with more-than-average credit risk, because they invest in below-investment-grade corporate loans. They’re comparable in credit quality to junk-bond funds, and some advisers contend that they’re even riskier. But that’s debatable. Moody’s trailing 12-month speculative-grade default rate was 2.9% in August, while the default rate for leveraged loans was 2.2%, according to the Standard & Poor’s SP/LSTA index.

Moreover, the economy will improve at some point, likely in tandem with rising interest rates. Fewer defaults should accompany a better economy.

Yes, in the calamity of 2008, bank-loan funds tanked by about 30%. But they rebounded by an even greater percentage the next year and have soundly beaten, on an annualized total-return basis, the benchmark Barclays U.S. Aggregate Bond Index every year since. And that’s been during an era of still-declining interest rates. As rates begin to rise at some point in the next year or two, the paramount advantage of bank-loan funds should reveal itself: the combination of impressive yield with almost nonexistent duration.

While bonds of every stripe carry exposure to rising rates, bank-loan funds are floating-rate securities, meaning the rates on the underlying loans are reset every 30 to 60 days. That means that their prices have almost zero sensitivity to interest-rate fluctuations, a metric known as duration. (Example: If a bond fund has a duration of 5.25, a 1% rise in interest rates will cause the value of the fund to decline by 5.25%.)

But because bank-loan funds regularly and frequently adapt to rate changes, they have virtually no sensitivity to rate changes. Hence, their duration is effectively zero. As rates rise, so will the yields of these funds. That said, they might not rise immediately, due to a rate “floor” that could exist on some of the underlying loans. But, really, who cares if you miss a single-point increase when the yield is already so good?

How good? Well, a proxy for the class would be the PowerShares Senior Loan Portfolio (BKLN), an exchange-traded fund that seeks to mirror the S&P/LSTA U.S. Leveraged Loan 100 Index. Based on its latest (October) monthly distribution of 8.3 cents per share, BKLN’s indicative annualized yield is 4.0%. By comparison, an ultra-short bond fund would likely yield less than 1.5% today, and have a typical duration of, say, 0.5, which on a relative basis is a lot more than zero.

Of course, the higher yield for BKLN, which is now a large holding in my Stable High-Yield portfolio, is compensation for the corresponding credit risk, just as it is with the yields for junk bond funds. Let’s compare the two classes:

The two largest junk-bond index ETFs, iShares iBoxx High-Yield Corporate Bond (HYG) and SPDR Barclays High-Yield Bond (JNK), each yield about 5%, just a tad more than BKLN. But they have substantially higher durations of 4.08 and 4.28, respectively. The bank-loan fund yields almost as much and will retain much more of its value in a rising interest-rate environment.

Are we in that environment yet? No, rates are slightly higher than six months ago, but there’s little expectation that they’ll move further until Fed tapering speculation again heats up. Still, that time is coming, with popular estimates now suggesting Fed action in March 2014.

The time to prepare for rising rates is now, and a modest allocation to bank-loan funds, a vehicle that mitigates rate risk, can be a prudent investment.

A final tip: Buy bank-loan ETFs instead of closed-end funds. The ETFs are likely to sell at a lower premium to net asset value.

Photo Credit: Steve Webel

DISCLAIMER: The investments discussed are held in client accounts as of October 31, 2013. These investments may or may not be currently held in client accounts. The opinions and views expressed herein are of the portfolio manager and may differ from other managers, or the firm as a whole. The information in this material is not intended to be personalized financial advice and should not be solely relied on for making financial decisions. Past performance does not guarantee future results.

John Gerard Lewis

John Gerard Lewis

I am John Gerard Lewis, a registered investment adviser representative based in Olathe, KS, and the Founder and President of

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Real Money

More than 30 investing pros with skin in the game give you actionable insight and investment ideas.

Product Features:
  • Access to Jim Cramer's daily blog
  • Intraday commentary and news
  • Real-time trading forums
Only $49.95
14-Days Free
14-Days Free
AAPL $93.74 -1.15%
FB $117.58 0.73%
GOOG $693.01 0.29%
TSLA $240.76 -2.81%
YHOO $36.60 0.03%


Chart of I:DJI
DOW 17,773.64 -57.12 -0.32%
S&P 500 2,065.30 -10.51 -0.51%
NASDAQ 4,775.3580 -29.9330 -0.62%

Free Reports

Top Rated Stocks Top Rated Funds Top Rated ETFs