Bank loan

Bank loan funds are back: here are 2 to consider

Bank loan funds lacked appeal for investors in 2019 and 2020 due to falling interest rates. But the economic recovery and the potential for higher short-term interest rates have put the category back in favor in 2021. Bank loan mutual funds have received net inflows of more than $13 billion for the year so far. day through April 2021, which was almost a quarter of the category’s assets at the start of the year. Demand for high yield bond funds has been more subdued this year despite the similarities of the two asset classes. While high yield bonds have greater upside potential, the defensive characteristics of bank loans make them an attractive means of portfolio diversification. The unique feature of floating rate bank loans, their hierarchy in the capital structure and the composition of the loan industry provide an attractive relative value opportunity compared to high yield bonds.

Although bank loans offer a lower yield than junk bonds, they have some attractive qualities. Coupon payments for bank loans float with the Libor every few months, and the loans therefore carry very little interest rate risk. When yields rise, bank loans hold their value, while fixed-rate bond prices fall. For this reason, the Morningstar bank loan category has outperformed the high yield bond category during historical periods of rising rates such as the taper tantrum in 2013 and the interest rate shock in the first half of 2018.

The seniority of bank loans relative to high yield bonds in the capital structure of many issuing companies is another attractive feature. While the average default rates for loans and bonds have been very similar over the past two decades, the average recovery rate for loans was 1.5 times higher than for bonds. Therefore, high-yield bonds may suffer more than loans during credit sell-offs. During the credit sell-off from February 20, 2020 to March 23, 2020, the median fund in the bank loan category fell 20.4%, while the median fund in the high yield bond category fell 21%. .2%. The bank loans category also outperformed by more than 100 basis points when credit markets sold off in the fourth quarter of 2018. Admittedly, these performance gaps are not large and bank loans also underperformed bonds. high yield in times of crisis, such as in 2008, when leveraged buyers unwound positions to meet margin calls. But their seniority in the capital structure should provide additional protection against permanent capital loss in the event of default, making loans generally preferable to bonds when defaults increase.

Moreover, the composition of the bank loan market contains fewer cyclical industries than the high yield bond market. Energy is the largest industry in the high-yield market and accounted for 13% of the Morningstar US High-Yield Bond Index in April 2021, compared to less than 3% for the S&P/LSTA Performing Loan Index. Instead, services, information technology and healthcare made up a larger portion of the bank lending market, leading to less volatile returns over time.

T. Rowe Price Floating Rate (PRFRX), which earned a gold rating from Morningstar analysts, is one of Morningstar’s top picks in the bank lending category. Lead manager Paul Massaro has led the strategy since its inception in 2011 and is supported by a strong credit research team. The team’s high conviction and selective approach has led to strong risk-adjusted returns since inception, and the strategy has performed well both during sell-off periods and in strong markets. The team chooses its spots carefully; it focuses on BB and B rated loans and selects CCC loans, which have generated the lowest total return and highest volatility relative to other credit rating levels over the past 25 years. The team’s picking ability has been demonstrated by its average default rate of 0.1% since its inception, while the bank lending market shows an average default rate of 3%.

Massaro and his team have also demonstrated strong cash management during times of credit stress and volatile fund flow. Maintaining a liquid portfolio is particularly critical for bank lending strategies, as loans take longer to settle and repayments have been particularly large when markets have crashed. The team typically keeps more than 5% of portfolio assets in cash and holds high yield bonds as a cash reserve before allocating loans. One of the recent concerns is the strategy’s asset growth in 2021 as bank lending has become popular. A deluge of inflows presents challenges for making cash work while maintaining high standards, but T. Rowe Price has earned a reputation for responsible capacity management by closing funds before asset growth can potentially impede the investment process of a strategy.

Silver Rated Fidelity Floating Rate High Income (FFRHX) is also a solid option. Fundamental credit research is a hallmark of Fidelity’s bank lending efforts. Experienced managers Eric Mollenhauer and Kevin Nielsen lead the strategy with the support of an in-depth supporting cast. Its 22-person analyst team as of September 2020 included two bank lending-specific analysts who look at loan originators only, while the rest of the cohort covers the entire capital structure across all sectors. In addition to the usual credit analysis, company management assessment and earnings forecasts, the team pays close attention to the structure and covenant package of each transaction. The strategy focuses on large companies – partly a necessity due to its size – but that makes it a more predictable and cautious choice among its peers.