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Floating Rate Bank Loan Funds—A Special Kind of High-Yield Investment

  • "When in doubt, punt."
  • John Heisman

Floating rate bank loan funds are relatively new members of the retail mutual fund universe, but they have proven themselves to be excellent tools during periods of unstable interest rates. In the current environment of low interest rates that is prevailing (April 2007), the 6.5%–7.5% available from floating rate funds is very attractive. Table 7.1 lists the yields available from different types of bond investments, as well as the relative levels of historical risk.

Table 7.1. Recent Yields to Maturity and Historical Price Risks for Different Types of Bond Investments

Type of Bond Investment

Current Yield (Yield to Maturity)

Relative Historical Risk

3-month Treasury bill

5.0%

None

10-year Treasury note

4.65%

Moderate

Investment-grade bonds overall (iShares Lehman Aggregate Bond Index ETF ticker symbol AGG)

5.2%

Low-moderate

High yield bond fund

6.6%4

Moderate-high

Floating rate bank loan fund

7.0%

Moderate

If you have ever taken out a mortgage, you have probably noticed that every couple of years you have to write down a new address to which you mail your payments or address your inquiries. This occurs because the bank or investor that had originally lent you the money for your house decided to sell your loan to another institution, just as you might sell a bond that you hold in a brokerage account. There is a similar, but much smaller niche in the bond market involving bonds backed by adjustable-rate loans that banks have made to businesses. It is in this relatively obscure corner of the bond market that one of the best-yielding, moderate-risk bond investments is found.

There are 29 distinct5 floating rate bank loan funds offered by 20 different mutual fund families. Of these, nearly half (14 of 29) were incorporated in 2002 or later, meaning that there is far less history for these types of funds than for most other types of stock or bond funds of interest to you as individual investors. The good news is that the earliest retail bank loan funds were launched in 1989, which gives us some glimpse into the pitfalls that might occur in the future.

The interest rates on the loans in which floating rate loans invest are adjustable, so there is no interest rate risk as there would be with a regular bond. In fact, if interest rates rise, you are better off because that will increase the amount of interest income paid to you as dividends. Moreover, adjustable interest rates tend to rise when inflation does, so this investment will probably not expose you to as much inflation risk as does a fixed-rate bond.

Credit risk is the main risk involved with floating rate bank loan funds. There is no guarantee that a corporate borrower will pay all the principal and interest due on a loan, nor that the collateral will be sufficient to cover its obligations. Earlier we mentioned high yield bond mutual funds—funds that hold bonds that have credit ratings below investment grade. The debt that bank loan funds hold tends to be from companies whose credit ratings are similar to those of high yield bond issuers. However, bank loans are generally better backed by collateral than high yield bonds are. As a result, when companies have defaulted on their debt obligations, holders of bank loan debt have fared better than holders of high yield bonds. (Generally, floating rate bank loan funds have at least 80% of their holdings in senior, secured debt. Senior debt is the first to get repaid in the event of a default, and "secured" means that there is specific collateral pledged to the repayment of the particular loan.)

Floating rate bank loan funds pay generous rates of interest compared to investment-grade bond funds precisely because of the credit risk. For example, as of early November 2007, floating rate funds are paying 6.5%–7.5% per year, which is 1–2%/year above what the typical investment-grade bond pays. In fact, yields are currently similar to what you can get from high yield bond funds, even though the latter have had significantly greater risk.

Floating rate funds vary widely with respect to the amount of risk they have experienced. The worst periods for floating rate funds occurred during the second half of 2002 and again in mid-2007. In 2002, the peak-to-valley losses in the value of floating rate funds ranged from 2% to 7%. From June-September 2007, losses in floating rate funds are ranging from 2%–4% but could extend further. Although there is no guarantee that future losses will not be more severe at some point in the future, 2002 was a period of low confidence in business, in which every type of corporate bond investment was punished for the sins of the stock market in general, and for corporate malefactors (such as Enron) in particular. The fact that a number of floating rate funds were able to weather that storm with only modest losses gives us some confidence in that sector.

There is one additional risk that these funds' price histories do not reveal. Unlike the case for mortgage-backed bonds, the market for bank loans is not very active. If one of these funds were to be hit with a wave of simultaneous shareholder redemptions, it could be very difficult for the fund manager to raise the necessary cash. As a result, bank-loan funds have various rules in place to protect them (and the funds' other shareholders) from the consequences of massive redemptions. Specifically, bank-loan funds require you to hold them for a minimum period, typically three months. In addition, many limit redemptions to specific dates of each month or quarter.

Lastly, bank-loan funds reserve the right to limit the total percentage of outstanding shares they will redeem at any one time. If more shareholders want to redeem than the fund allows, each shareholder gets only a pro-rata share of their request. For example, the Oppenheimer Senior Income Fund limits redemptions to between 5% and 25% of outstanding shares each quarter. The fund gives notice a few weeks in advance of how many shares they are prepared to redeem, and requires advance notice from shareholders as to how much they want redeemed. If the fund announced a willingness to redeem 5% of outstanding shares, but shareholders tendered 15% of shares for redemption, then each shareholder would get out of only one-third of his shares. Details are in the prospectus for this fund.6 During the summer of 2007, some floating rate funds did receive more requests for redemptions than they were prepared to honor, so shareholders were not able to access their cash.

During periods of stable or rising interest rates, floating rate funds are excellent candidates for part of your portfolio. Table 7.2 lists some of our favorite floating rate funds.

Table 7.2. Selected Floating Rate Funds with Current Yields as of March 2007

Fund Name

Ticker Symbol

Current Yield

Comment

Oppenheimer Senior Floating Rate

XOSAX

7.0%

Can only redeem on one specific date every three months.

Hartford Floating Rate

HFLIX7

6.5%

ING Senior Income

XSIAX

6.5%

Can only redeem from this fund on the tenth business day of each month.

Highland Floating Rate

XLFAX

7.2%

Can only redeem on one specific date every three months.

As with any mutual fund, you should not pay an upfront or deferred sales charge in order to purchase these. Rather, utilize a discount brokerage house where these shares are available without sales charges (although modest transaction charges may be involved).

Which brings us back to the quote by John Heisman at the beginning of this section.... If you are uncertain about the market climate but want to earn potentially more than you could in a money market or bank CD, floating rate funds are a way to go. However, the restrictions on redeeming your assets from these funds once you invest renders these unsuitable for money to which you might need ready access on short notice.

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