Anthony Clemente, who manages the AIM Floating Rate fund, evaluates the reputations of the private equity sponsors that have large stakes in many of the companies that tap the bank loan market to make acquisitions. He also looks at industry positioning, asset quality and the ability of a company to sell off parts of itself to repay its debt. He prefers larger-capitalization loans of $200 million or more because of their superior liquidity. A growing number of the loans he invests in are in service sectors such as chemicals and transportation, which stand to benefit from a cyclical economic recovery.
Differences in management strategies mean that returns, particularly over short periods, can vary dramatically between funds. Factors that influence performance include:
Credit quality. While most bank loan funds focus on below-investment-grade credits to boost yield, some gravitate toward the better-quality end of the junk spectrum. Others prefer to take a somewhat higher degree of credit risk, including some investments in distressed companies, to achieve higher returns. Managers may become more aggressive in their credit stance if they see an economic rebound on the horizon, or they may gravitate to more conservative credits when defaults are on the rise.
Page generally prefers a more conservative strategy. "This is not the best asset class to take a high-risk, high-return approach," he says. "The point of investing in bank loans is to get a little extra yield and good protection against downside risk."
Sector allocation. In 2002, funds that invested heavily in loans to telecommunications companies lagged more conservative peers that positioned themselves in defensive sectors such as health care. So far this year, a rebound in the telecommunications industry and a strengthening economy has put those former laggards ahead.
"People were in a panic about weakness in the telecommunications industry," says Derek Schug, director of investor services at Columbia Management Group, which offers two bank loan funds that have invested in that sector more heavily than many of their peers. "But we recognized the underlying value of telecommunication company collateral assets." He adds that loans in wireless are less volatile than the sector's bonds or stocks, and that the fund balances out aggressive positions in the media and telecommunications sectors with loans in more defensive industries such as health care and food.
Leverage. Some funds use leverage for investment purposes, while others do not. As with other types of investments, the strategy is a double-edged sword. If the investment performance falls short of borrowing costs, the fund's shares could decrease in value more rapidly than in a nonleveraged fund, and dividends on the shares would be reduced or eliminated. On the other hand, the value of fund shares would rise and dividends would increase if the return from the bank loans exceeds the cost of borrowing. Although leverage increases risk, its impact is more muted than it would be in a strategy involving stocks or bonds because rising yields on the variable-rate portfolio loans offset higher borrowing costs.
The difference in returns between the Columbia Floating Rate Fund and the Columbia Floating Rate Advantage Fund illustrates the impact of investment borrowing in a bank loan fund. While both have essentially the same portfolios, the latter fund's use of leverage boosts its current yield to 5.53%, compared with 3.93% for its nonleveraged sister. But when default rates peaked in the third quarter of 2002, the nonleveraged fund's net asset value declined by 4%, compared with a 6% decline for the leveraged fund. Rising yields and improving credit quality combined to help produce a total return of 11.29% for Columbia Floating Rate Fund during the first three quarters of 2003, compared with a leverage-amplified return of 15.73% for Columbia Floating Rate Advantage.
Bonds in the portfolio. Some bank loan funds try to spice up total returns by adding high-yield bonds to the portfolio mix, while others focus solely on bank loans. Eaton Vance Floating Rate High Income Portfolio, for example, devotes 15% of its assets to high-yield bonds.
Opinion differs about whether redemption features influence returns. Schug and Clemente maintain that funds that limit redemptions to four times a year, as theirs do, have a built-in advantage because they need to keep less low-yielding cash on hand to meet redemptions than funds that allow investors to cash out every day. Page of Eaton Vance calls that observation "absolute bunk." He says that the higher quality of the loans in the portfolio, not higher cash levels, account for his funds' slightly lower yield compared with competitors with more restrictive redemption features.