Why Are Loan Participation Funds Underperforming?
What's going on with loan participation funds, particularly Pilgrim Prime Rate Trust (PPR) and Eaton Vance Senior Income (EVF)? Values have dropped by 8% to 10%. I know general rates are up, but both are supposed to buy floating-rate loans.
-- John W. Anderson
John,Loan participation funds are curious indeed. They are supposed to perform well when interest rates are going up. Unfortunately, controversy over how their assets are valued appears to have triggered some dumping of the shares. But closed-end fund analysts say that the markdowns make this a good time to buy the funds. Loan participation funds, for those not familiar with them, are comparable in some ways to high-yield bond funds -- both types of funds invest in the debt of companies with low credit ratings. But loan participation funds -- which buy bank loans to the companies, as opposed to bonds issued by them -- are less risky than high-yield bond funds in two key respects. First, lenders have a higher claim on company assets than bondholders do, meaning that in a bankruptcy situation, lenders are more likely to recover their investment. Second, while bonds have fixed interest rates, loans have floating rates. When interest rates rise, bonds lose value because their fixed interest rates become below-market. But loans hold their value because their interest rates follow the market higher, allowing loan participation funds to raise their dividends. That makes them "an extraordinarily effective hedge on the income side" of a portfolio, says Kristoph Rollenhagen, closed-end fund analyst at Prudential Securities. Of course, when interest rates are declining, the interest rates on the loans go down, leading loan participation funds to cut their dividends. As a previous Fixed-Income Forum explained in greater detail, there are more than a dozen loan participation funds, but only five of them are exchange-listed -- the two you mentioned, Nuveen Senior Income (NSL), Travelers Corporate Loan (TLI) and Van Kampen Senior Income (VVR). As with any exchange-listed closed-end fund, these funds can trade at prices above or below their net asset values. Because their relative immunity from interest-rate risk keeps their net asset values relatively stable, it is unusual to see a loan participation fund trade at much of a premium or discount to its net asset value. It's particularly unusual to see loan participation funds trading at a discount at a time when the Federal Reserve is raising interest rates, allowing the funds to raise their dividends. And yet, as of mid-April, the five funds were trading at an average discount to net asset value of 12.46%, according to a report by Michael McGrath, closed-end fund analyst at Gruntal. Over the year ended April 1, the funds had increased their dividends by an average of 17.03%, McGrath calculated. These charts show the damage.
|Nuveen Senior Income |
|Travelers Corporate Loan |
|Pilgrim Prime Rate Trust |
|Van Kampen Senior Income |
|Eaton Vance Senior Income |
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