Berko: Are bank loan funds a safe bet?
Friday, October 25, 2013 7:00 AM
Dear Mr. Berko:
I have eight $50,000 certificates of deposit coming due in the next eight months, one of which comes due next week. I asked the bank officer about bank loan funds because my neighbor owns one yielding 3.9 percent, which is a lot better than the 0.75 percent return the bank pays on a CD. And what are floating-rate funds? The bank guy knows nothing about them but really tried hard to push me into an annuity paying a 5 percent rate. I’d appreciate your advice and recommendations.
The friendly guys and gals who adorn the chairs and desks in bank lobbies don’t know bupkis about bank loan funds, but they’re certainly an impressive cadre of enthusiastic annuity salespeople. I imagine that if I were selling a product with commissions between 6 and 12 percent, it wouldn’t take me long to be enthusiastic, either.
Bank loan funds, which are really floating-rate loans, pay an interest rate that’s tied to the London Interbank Offered Rate, which may still be manipulated by Wall Street banks to goose their income statements. Libor, as it’s known, is sort of a wholesale rate that banks charge each other for short-term loans. As the Libor moves up or down, the rates on bank loans are adjusted accordingly (every 30 to 90 days), which is why they are called “floating-rate” loans. Investors find this feature attractive, especially in a rising-interest-rate environment. Because rates have been rising for the past few months, investors with floating-rate funds should have small increases in distributions while the market value of their investments remains basically stable. But fixed-income fund investors experienced a drop in distributions and a decline in the market value of their investments and worry the world may be coming to an end.
Many floating-rate loans are issued by companies that are rated below investment grade. However, the loans are secured by attractive and relatively liquid collateral, such as equipment, real estate, accounts receivable and inventory. This collateral helps shield investors in the event of default, giving them a modest feeling of security and comfort. This collateral also confers seniority to the loan and puts the loan holder (you) ahead of other lenders in the event of bankruptcy. In these circumstances, holders of bank loans are likelier than equity holders and holders of unsecured bonds to recover all or part of their investment.
Because the duration of a bank loan is measured in days, there’s minimal rate risk when interest rates rise, so the investor’s major concern is credit risk. Therefore, bank loan funds are almost pure credit investments, given their minimal sensitivity to interest rate changes. And in the past few years, the default rate within the bank loan sector has remained below 2 percent. The rate is expected to drop even further, according to the trusted wizards at Standard & Poor’s, who are paid handsomely to rate our investments. But if the economy has a butt kick like the one it suffered a couple of years ago, all bank loan funds will take a hit. So will AAA companies and the bluest of the blues. Still, these funds tend to be less volatile than fixed-income investments, and in a low-rate environment, bank loan funds have attractive returns. And as interest rates rise, as you know they will, the distributions on these investments will rise, too. So it’s comforting to know that you won’t be left holding the bag and sucking your thumbs like other investors.
The largest of the genre is an exchange-traded fund, the $5.5 billion PowerShares Senior Loan Portfolio (BKLN-$24.78), which yields 4.64 percent and pays monthly. Lord Abbett’s $7.6 billion floating-rate fund (LFRAX-$9.50) yields 4.87 percent and pays monthly. And Virtus’ $1 billion senior floating-rate fund (PSFRX-$9.84) yields 4.72 percent, pays monthly and may be my favorite. There are more floating-rate funds out there than you can wag a finger at. But it’s easy to make a mistake, so I urge you to hire a knowledgeable and wise broker to help you select the best fund and assist you in investing the remaining seven CDs.
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