(PUB) Investing 2015

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Bank-Loan Funds Are Cause for Concern The Contrarian | Russel Kinnel

won’t see an increase in yields on many loans until short-term yields rise by more than 75 basis points. Thus, there will be a lag that may surprise investors who thought they were getting greater protection against rising rates than they are. We’ve already gotten a whiff of the challenges ahead, however. Flows into bank-loan funds have become pretty erratic. In 2014 , three funds had a single month in which more than $1 billion net left the funds. Two of them had to tap a line of credit to ensure a smooth exit for shareholders, though they report they only needed it for a couple of weeks. I have no problem with tapping lines of credit—that’s the point of having them. But this does illustrate the challenges of managing a limited-liquidity asset class in a daily liquidity format. Ten funds have endured outflows of at least $1 billion for the 12 months ended June, and three have seen more than $4 billion flow out: Oppenheimer Senior Floating Rate OOSAX , Fidelity Advisor Floating Rate High Income FFRAX , and Eaton Vance Float- ing Rate EIBLX . We have lowered the Morningstar Analyst Ratings of the Oppenheimer and Eaton Vance funds to Neutral and Bronze, respectively, because of the challenges presented by redemptions. I don’t want to suggest disaster is lurking—only that we haven’t seen these funds tested by a recession since they became big. There are some positive factors here, too. Bank loans are more senior than high-yield debt and thus should get better recoveries if the default rate picks up. Most of the big man- agers of bank loans have experience and depth to manage redemptions. And despite the redemptions, the average bank-loan fund is up about 1% for the trailing 12 -month period. Given these challenges, there are a few ways to respond. Obviously, you can avoid the category completely, or you can buy a closed-end bank-loan fund where redemptions are not an issue. How- ever, they have leverage, so you’re merely exchanging one kind of risk for another. You can also choose a fund like Fidelity Advisor Floating Rate High Income that takes a more conservative approach. K

When the first bank-loan mutual funds came out, they were interval funds in which investors could only add or subtract money at month- or quarter-end. Bank loans don’t have the liquidity of standard corporate debt, so fund companies wanted to ensure that flows could be handled in an orderly fashion. But fund investors love the daily liquidity of mutual funds. Even if they hold their funds for a decade, investors have peace of mind knowing they can get out at any time. Thus, it wasn’t surprising that as the bank-loan market grew, the fund industry slowly moved to daily liquidity funds. Fidelity was the first, and its answer to the liquidity challenge was to hold a sizable cash stake and ensure that some of the bank-loan portfolio was of the most liquid issues. That meant sacrificing some returns, but it seemed a practical solution. Gradually the industry followed Fidelity’s lead in moving to daily liquidity, though many of the next generation of bank-loan funds were less cautious about building a cash hoard for rainy days. As people worried about rising interest rates, the appeal of a bond class in which yields were adjusted to interest-rate shifts grew. The category grew from $8 billion in 2003 to $12 billion in 2008 and then all the way to $138 billion at the end of 2013 . That brings us to the challenge facing bank-loan funds today. They were still a tiny part of the bank-loan market in the 2008 – 09 recession. Now they are quite big, though there are other big owners of bank loans outside the mutual fund world, and we really don’t know how the funds and fund investors will behave in the next recession. In addition, there’s a potential for disappointment when rates do rise. Bank-loan yields are pegged to Libor, a short-term rate, so they don’t respond to increases in long-term bond yields. Because many bank loans have Libor floors, investors

Our Contrarian Approach I go against the grain to find overlooked funds that may be ready to rally.