4 Solid Bank-Loan Funds
Karen Wallace: Rising interest rates have held back returns in most domestic bond categories in 2018, but the bank-loan category is in the black for the year to date. Here to discuss some of the performance drivers and some of our analysts' picks in the category is Brian Moriarty. He is an analyst in our fixed income manager research group.
Brian, thanks so much for being here.
Brian Moriarty: Happy to be here. Thank you.
Wallace: First off, let's discuss what bank-loan funds are and how they work.
Moriarty: A bank loan is a debt instrument that pays a floating coupon. This coupon is pegged to three-month LIBOR. So, as LIBOR rises so will the coupon paid by the bank loan. Now, this also works in reverse. As LIBOR falls so will the coupon paid by the bank loan. But this means that bank loans are one of the few fixed-income instruments that is protected from rising interest rates.
Wallace: They don't take on a lot of interest-rate risk, but they are subject to other types of risk.
Moriarty: Correct. There are two primary risks associated with bank loans. First is credit risk and liquidity risk. On the credit side, bank loans are issued by below investment-grade-rated companies which means bankruptcy is a very real concern. On the liquidity side, bank loans are still technically private securities, which means they can take seven to 20 days to trade and settle. Now, this is a significantly long time, longer than high-yield bonds or other securities. Taken together, this increases the risk of the securities and they can fall significantly in scenarios like 2008 when the bank-loan category lost 30%.
Wallace: With some of those risks in mind, does it make sense for every investor to have a bank-loan allocation? Or how should people think about using bank-loan funds in their portfolio?
Moriarty: Investors should really look at bank loans as comparable to high-yield bonds. If they already have an allocation to high-yield bonds in their portfolio, then they might want to consider bank loans. One thing to keep in mind is that bank loans are actually senior to high-yield bonds in the capital structure, which means that they will hold up better during a sell-off than a high-yield bond and in bankruptcy, they actually have a higher recovery rate. Think of them as a more defensive form of credit risk. But unless an investor is already willing to take that credit risk, bank loans are not for them.
Wallace: Finally, what are some bank-loan funds that you and the team recommend?
Moriarty: On the conservative side of the category is a fund like Pioneer Floating Rate or Voya Floating Rate. These are the very defensive higher-quality funds for a conservative investor. Moving out into the middle of the risk spectrum is a fund like Credit Suisse Floating Rate High Income which plays a little bit more tactically based on valuations. At the most aggressive end is a fund like Eaton Vance Floating-Rate Advantage, which actually uses leverage to boost its returns.
Wallace: Thanks so much for being here to discuss this.
Moriarty: Happy to be here. Thank you.
Wallace: For Morningstar, I'm Karen Wallace. Thanks for watching.