Research shows that senior floating-rate loan fund portfolios are on the right track with active management because this market can be highly inefficient. A 1995 Journal of Portfolio Management study, "Corporate Loans as an Asset Class," by Elliot Asarnow, currently chief operating officer of BlackRock Private Equity Partners, New York, suggests that financial advisors should tactically allocate senior loan funds to a client portfolio. The study found that an actively managed portfolio of floating-rate corporate loans displaced Treasurys and high-grade corporate bonds in low-to-medium-risk, multi-asset-class portfolios.
Other financial research reveals that during periods of rising interest rates, the Credit Suisse Leverage Loan Index performs well. In the rising rate period of February 1994 through February 1995, floating-rate senior bank loans gained 10.4% compared with .01% for bonds, according to research by Eaton Vance. Meanwhile, in the rising rate period of June 1999 through May 2000, senior floating-rate loans gained 3.9% while bonds gained 2.1%.
In the more recent rising rate period of June 2004 through June 2006, senior floating-rate loans gained 12.7% while bonds gained 6.6%.
There is no free lunch. During periods of declining interest rates, advisors may have to adjust their senior loan fund positions. That's because bank loans don't fare as well as high quality bonds.
A study by the Financial Planning Association of Southern Wisconsin reports that during 2001 and 2002, when bonds and mutual funds were performing well, floating-rate senior loan funds barely broke even. Defaults hurt floating-rate senior loan funds during those times.
Advisors also need to monitor the duration of their overall fixed-income portfolio when it includes senior floating-rate loans. The duration of floating-rate loans can change as credit risk changes, according to a study, "The Pricing and Duration of Floating-Rate Bonds," published in the 1987 Journal of Portfolio Management. Jess Yawitz, its senior author, is chairman of NISA Investment Advisors, St. Louis.
Market technical problems also are a variable to consider when investing in these loans. Eighty percent of more than $600 billion in senior floating-rate loans issued by 1,600 companies are held by institutional money managers, including hedge funds and collateralized loan obligations.
Russ, of Eaton Vance, says that during the financial collapse, the credit markets froze. Margin calls and market value triggers forced the liquidation of creditworthy assets across asset classes. And in 2008, published reports indicate about 175 issuers defaulted on $125 billion in loans. Investors recovered just 60 cents of every dollar on defaults.
It is important to monitor the volatility of senior loan mutual funds. There was little liquidity in the senior loan market during the financial crisis, so volatility increased swiftly and dramatically. As a result, financial advisor asset allocation models may have failed to adjust for the risk.
In the period before the collapse of Lehman Brothers, from January 2000 to September 2008, the Credit Suisse Leverage Loan Index grew at a rolling five-year annual rate hovering around 5%, with a standard deviation of 2% to 4%, according to a report by Babson Capital, Norwalk, Conn. After the Lehman default, the standard deviation on the loan index return doubled to 8%. Loan returns declined at nearly -5% annually, based on five-year rolling returns from January 2000 through June 2010.
Financial advisors should do their credit homework before they invest in senior loan mutual funds, closed-end funds or exchange-traded funds, suggests a working paper led by Hinh Khieu, assistant finance professor at the University of Southern Indiana, Evansville, Indiana. His research of senior loan defaults over the past 20 years reveals that companies with high levels of overall debt on their books and poor quality collateral resulted in investors recovering less after a default.
"Firm leverage before default negatively affects ultimate recoveries, while borrower cash flows do not," he says. "Firm size influences recoveries differently across different types of loans. A variety of loan contract features are strongly related to the ultimate payoff for creditors. Secured loans have higher recoveries, and among the types of collateral, inventories and accounts receivable result in the highest recoveries. Prepackaged bankruptcy reorganization increases actual settlements."