U.S. Treasury yields are at record lows with no relief in sight, causing financial advisors to search for new sources of yield. One popular alternative strategy has been “floating rate” funds that invest in short-term bank loans made to leveraged companies. These floating rate bank loans are often pegged to Libor and their rates are reset frequently––typically every three months or less. Their short duration and variable rates that “float” when market conditions change can help protect against rising interest rates.

And from an income perspective, the collective group of bank loan mutual funds tracked by Morningstar Inc. sports an appealing current SEC yield of 4.5 percent (as of January 31).

That said, there are obvious risks associated with lending to highly leveraged companies. “Bank loans have little interest rate risk, but they do have credit risk,” says Sarah Bush, a senior mutual fund analyst at Morningstar. “Most companies seeking bank loans are below investment grade.”

Bush notes that fund flows into the floating rate space gained steam last August and have remained strong with $3.6 billion in inflows in the third quarter, $6 billion in the fourth quarter, and $4 billion this past January. “Any time people get worried about rising rates, they start looking at bank loan funds,” she says.

“These funds are something that would do well in a growing economy with a rising inflation rate,” she continues, noting that a healthy economy helps these companies increase sales and cash flow, while the reset in interest rates helps protect against rising inflation.

But bank loan funds can incur losses during rough patches for the economy and the stock market. “Its really important that potential investors in these funds assess their level of patience in riding through volatility,” Bush says, adding that this asset class lost 30 percent in 2008 and dipped 4 percent during the market swoon of August/September 2011.

Christopher Graff, principal and director of asset management at RMB Capital Management, a Chicago-based investment advisory firm, says that bank loan funds tend to perform well in periods of fundamental strength in the credit markets.

“They also generally perform well when short-term interest rates rise on an absolute basis, particularly relative to other fixed income sectors,” he says.  

Graff says he’s reviewing his current allocation to bank loan funds. “Generally speaking, within our opportunistic fixed income allocation—that is, the riskier portion of our fixed income allocation—we currently allocate 15% of it to these types of funds,” he says. “This allocation is roughly in line with our historical average level, but we are actively considering increasing their weight.”

Spread Out

Spreads measure yields relative to other market rates, generally Libor or Treasuries. If Libor is 1 percent and bank loans yield 5 percent, the spread is 4 percent. Relative spreads are useful ways to measure yields across fixed income categories, and are particularly helpful now with historically low Treasury yields driving down rates across the bond market.

Given that backdrop, floating rate bank loan funds appear to be reasonably priced on a relative yield basis. According to JP Morgan analyst Peter Acciavatti, the spreads on bank loans relative to Libor are currently 511 basis points, a number that has remained steady since 2008 and is above the 2007 pre-crisis level of 377 basis points.

Graff believes bank loans are decently priced relative to Treasuries but aren’t cheap on an absolute basis. “Absolute yields are currently near historic lows,” he says. “Spreads today are tighter than their long-term average, but still wider than their all-time lows.”

In other words, bank loans are a decent house in a bad neighborhood.

Fund Options

There are an ever-growing number of funds in the bank loan space. Morningstar tracks 41 mutual funds in this sector, and three new funds launched in the fourth quarter alone, including one from DoubleLine. There are also two exchange-traded funds focused on bank loan exposure––the PowerShares Senior Loan Port (BKLN) and the Highland/iBoxx Senior Loan ETF (SNLN).

Both Bush and Graff say investors need to look beyond the numbers when selecting these funds.

“Don’t buy these funds solely on yield because entrants in this category have differing risk approaches,” Bush says. “Some use leverage to enhance returns, some use high-yield bonds, and credit quality varies.” She notes that the ING Senior Income fund (XSIAX) tries to boost returns with leverage, while the Credit Suisse Floating Rate Hi Inc Institutional fund (CSHIX), has converted from being a strictly high yield bond fund to a floating rate fund.

Bush's favorite names in the group are Fidelity Floating Rate Hi Income fund (FFRHX) and the Eaton Vance Floating Rate fund (EABLX). “We favor relative conservative funds with lower yields,” says Bush, who also assigns a negative rating to one fund, the Lord Abbott Floating Rate Fund (LFRAX) due to management turnover.

Graff also likes the FFRHX and EABLX funds. “We usually prefer the more conservatively positioned bank loans funds,” he says. “We are willing to give up some upside potential in order to have superior downside protection. The Fidelity Floating-Rate High Income Fund and the Eaton Vance Floating Rate fund are two funds we think serve that purpose well.”

For advisors looking to maintain current yield while protecting against rising rates, floating rate funds can be a valuable addition to clients' portfolios. Advisors should be mindful of the credit risk of these products and not view them as a substitute for money market funds.