Despite their red-hot appeal, bank loan funds aren't on Brian Frederick's investment shopping list. A principal at Stillwater Financial Partners in Scottsdale, Ariz., the financial planner doesn't suffer from short-term memory when it comes to another rise in popularity for the asset class, which went over the cliff in the Great Recession.
"Bank loan funds got hammered in 2008 and 2009," Frederick said. Yet people thought they were safe because they held senior bank loans, which means they're the first to be repaid during defaults. Despite this cushion, bank loan funds lost 30 percent in 2008, according to Morningstar data.
Short-term memory seems to be fine for many, though. Afraid of rising interest rates, investors have stampeded into floating-rate bank loan funds this year. Assets have soared. The $49 billion put into bank loan funds in 2013 is more than flowed into them in the past eight years combined, according to Lipper data.
Bank loan funds are mutual funds made up of loans to corporations made by banks and other financial outfits. They are also called floating rate funds, because they don't pay a fixed interest rate but rather an adjustable one.
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The lure is those bank loans' short duration—30 to 90 days, "so there's no interest rate risk," said Sarah Bush, a senior mutual fund analyst at Morningstar. Another plus is that loans held by funds have a floor pegged to Libor, so yields reset when interest rates rise.
But Frederick isn't buying it, and he isn't alone in hesitating to follow the masses into bank loan funds in response to rising rates.
Experts worry that investors are ignoring the risks of low-rated bonds as default levels decline and the economy picks up speed. In August, the default rate for leveraged loans was 2.2 percent, according to Standard & Poor's SP/LSTA index. Yet Frederick and others argue that bank loans are arguably even riskier than junk bonds.
"These companies have a hard time even issuing junk bonds," Frederick said about bank loans.
Allan Roth, founder of advisory firm Wealth Logic, said taking on more credit risk to mitigate interest rate risk is not logical.
"Between credit risk and interest rate risk, boy, I would I rather take on rate risk," he said. "Interest rate risk, you lose the opportunity cost of yield; credit rate risk, you lose everything."
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Roth, who avoids bank loan funds, does own a small percentage of high-yield bonds for clients, but he considers the high yield as a portion of his equities portfolios rather than part of the fixed-income allocation.
"I'm buying the best of junk, the nicest house in a bad neighborhood, and I bought it in 2008 when it was being run from, just a tiny bit," he said.
In the view of many financial advisors, fixed income should be a portfolio's shock absorber, and the last thing a client needs is a fixed-income holding that performs as poorly as equities if the market tanks: the 2008 scenario for bank loan funds.
"Even high-quality high yield is not a shock absorber," Roth said.
Bush worries that bank loans will sell off quickly if there's another flight to quality. She also noted that these investments have very little call protection. If called, the loans can be repaid at par, which means that investors who overpay can lose money.
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