Bank-Loan Funds Offer Steady Returns

NEW YORK ( TheStreet ) -- Although most bonds have sunk lately, bank-loan funds stayed afloat.

This year PowerShares Senior Loan Portfolio ETF ( BKLN) has returned 2.4%, compared to a loss of 2.3% for the Barclays Capital U.S. Aggregate bond benchmark, according to Morningstar.

Investors have taken notice, pouring $3.7 billion into the ETF this year, according to IndexUniverse.com.

The PowerShares ETF pays an attractive yield of 4.6%. If the economy avoids falling into recession, the fund seems poised to deliver returns of at least 4% to 5% in the next year. That could be a healthy result compared to what most bonds will deliver.

Bank loans have long been favored by investors seeking ways to diversify portfolios. Because of their unusual structures, the loans have little correlation with Treasuries or other high-quality bonds. The funds typically invest in loans that have been made to borrowers with below-investment grade credits. During periods of rising rates, most bonds sink as investors sell existing issues with low yields. But loans avoid trouble because they offer adjustable rates. As rates rise, borrowers must pay more, and yields on loan funds rise.

During most years, loan funds produce single-digit returns. In hard times when investors worry about defaults, loan prices may dip, and returns can be skimpy. But most often, prices soon recover. With investors unnerved by the European crisis, loan prices softened in 2011. For the year, bank-loan mutual funds returned 1.6%. But the next year, prices rebounded, and the funds returned 9.4%. During the turmoil of 2008, leveraged hedge funds dumped loans at depressed prices. For the year, loan funds lost 29.7%. In 2009, the funds rebounded from the losses, gaining 41.8%.

Bank loans tend to be more stable than high-yield bonds, which are issued by below-investment grade companies. The loans are backed by collateral, such as real estate or equipment. In the event of a default, the owners of loans must be paid first, while investors in high-yield bonds wait at the end of the line.

On average, 3% of loans have defaulted annually, compared to 4.8% of high-yield bonds. With the economy recovering, the loan default rate is currently running around 1.4%.

Because corporations hold plenty cash on their balance sheets, defaults should remain subdued, says Timothy Strauts, a Morningstar analyst. "This year we should see minimal losses from defaults," he says.

If the economy slips into recession, defaults will climb. But Strauts says that bank-loan funds can deliver positive returns in typical recessions. Since Morningstar began tracking bank-loan funds in 1989, the category recorded losses in only one year -- 2008.

Strauts says the loans suffered in the financial crisis because borrowers were heavily leveraged. These days, borrowers are on much sounder footing. "There is much less leverage in the system now," he says.

For investors seeking a solid mutual fund, a top choice is Eaton Vance Floating Rate ( EVBLX), which yields 4.0%. The fund tends to shy away from securities that are rated triple-C, near the bottom of the quality spectrum. Instead, Eaton Vance keeps most of its assets in loans rated double-B and B, the top two grades in the below-investment grade market. "The CCC segment is much more volatile and has default risk," says Christopher Remington, an institutional portfolio manager for Eaton Vance.

To boost returns, some mutual funds hold big positions in triple-C-rated loans, which currently yield more than 12%. In contrast, double-B-rated loans yield 3.5%, and B issues yield 4.5%. The lack of triple-C-rated loans hurt Eaton Vance this year, because low-quality issues delivered the best performance. But the low-quality issues can suffer in downturns. Because of its quality focus, Eaton Vance tends to excel in downturns.

At the time of publication, Luxenberg had no positions in securities mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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