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TheStreet Open House

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

What happened? At least three things.

First, you'll notice from the charts that each of the funds (with the exception of Nuveen Senior Income, which was launched very recently) has experienced a bit of net asset value deterioration. This is due to credit problems, analysts say. Loans may be more secure than high-yield bonds, but they're still junky debt. Borrowers still default, and loan values have to be written down. Over the last year, defaults have increased. The loan sector in particular has been plagued by defaults by nursing home borrowers due to changes in Medicare, McGrath says. When net asset values deteriorate even slightly, some investors bail, and discounts can widen.

Second, investors have reason to fear that the default rate won't improve any time soon. Even though loan participation funds should outperform fixed-rate bond funds when the Fed is raising interest rates, at a certain point the higher rates become burdensome for borrowers. McGrath notes: "A higher interest burden could increase the level of defaults and potentially increase net asset value volatility going forward."

Third, and probably most important, loan participation funds have come under scrutiny in the last six months for how they price their loans in order to calculate their net asset values.

Loans trade even less frequently than bonds, meaning that there may be no recent information on which to base a determination of how much a loan is worth. Historically, loan participation funds made their own decisions about how much their assets were worth, rather than relying on independent pricing services.

That practice was criticized by the Securities and Exchange Commission in December. The commission said assets should be valued at the prices at which they could be sold. A tall order, since by definition, illiquid assets can be sold only at a discount.

In the last several months, the funds have begun using independent valuations of their most liquid assets when calculating their net asset values, with little apparent impact. But the issue has triggered some dumping of loan participation fund shares, analysts say. "The fear is that net asset values could move much further down if the funds were forced to price everything" according to what it would fetch in the market, says Mariana Bush, closed-end fund analyst at First Union Securities.

Other factors that have affected loan participation fund pricing over the last six months are tax-loss selling and analyst actions. Tax-loss selling was a factor because until 1998, there were only two exchange-listed funds -- Pilgrim Prime Rate and Van Kampen Senior Income -- and they often traded at a premium. As the sector has grown, the premiums have gone away, leaving some investors with losses. Meanwhile, swap recommendations among the various funds by Morgan Stanley Dean Witter in particular appear to have affected prices.

In the month since you wrote, the discounts to net asset value at which the five exchange-listed funds were trading have narrowed somewhat, indicating that some investors decided that enough was enough. At the average discount of 12.46% in mid-April, the funds offered yields of 10.4% on average, according to McGrath's report. "The dynamic of rising dividends in a rising interest-rate environment is starting to play out again, attracting investors back into the sector," he says.

Whether investors stay will depend on how the factors that got the funds down in the first place play out.


Send your questions and comments to fixed-incomeforum@thestreet.co m , and please include your full name. Fixed-Income Forum appears each Friday.

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