As interest rates continue to rise, the number of fixed-income funds invested in bank loans instead of bonds may increase as well. Historically the province of retail investors, in recent years these funds have been offered to institutional investors.
The Liberty Stein Roe Advisor Floating Rate Fund, launched in 1998, was the first. It and two Eaton Vance funds -- the Eaton Vance Senior Floating Rate Fund and the Eaton Vance Advisor Senior Floating Rate Fund -- are the only bank loan funds available to institutional investors.
But if interest rates keep rising and the bond market continues to suffer, those funds have the potential for filling a larger niche.
While they are susceptible to credit risk, bank loan funds are not as affected by interest rate fluctuations as other fixed-income funds.
Brian Collins, consultant at Mercer Consulting, said pension fund managers have been showing interest in bank loan funds as a potential alternative to high-yield funds in the last couple of years, but at present, few are invested in this relatively new strategy. One of the reasons, said Mr. Collins, is that the funds -- which Lipper Inc., Summit, N.J., categorizes as loan participation funds, and other firms call senior loan funds or floating rate funds -- haven't been around long enough to have a track record.
Loan participation funds invest in bank loans made to companies for financing operations. These loans typically are less than investment grade, so they seek higher levels of income -- similar to high-yield funds -- and are subject to credit risk. Unlike traditional fixed-income investments, however, floating rate loans do not pay a fixed rate of interest. Rather, the interest rates generally are tied to a benchmark -- such as the London InterBank Offered Rate index -- and payments periodically are adjusted to market levels, usually 30 to 90 days.
While high-yield funds have posted average returns of 10.6% over a 10-year period, in the past year they have been outperformed by loan funds. In the first quarter, high-yield funds returned -1.52%, according to Lipper, and for the year ended March 31, the asset class broke even with a return of zero. The loan participation funds, on the other hand, returned 1.5% for the first quarter and 6.5% for the year ended March 31.
"There's not a lot of places to hide in the fixed-income market today," said Brian Good, co-portfolio manager -- along with James Fellows -- of the Liberty Stein Roe Floating Rate fund. When interest rate risk is eliminated or reduced from an asset class, explained Mr. Good, "you've got a very different risk-return relationship than a typical fixed-income security." Because the income component of the bank loan funds goes up and down as interest rates go up and down, he explained, "The (loan participation) asset class actually has the most benefit in a rising interest rate environment. What other asset class actually benefits from increasing rates?" Because its lack of correlation with other investments, Mr. Good said bank loan funds are "a powerful diversifier" even among fixed-income investments.
The Liberty Stein Roe Floating Rate Fund, which has $150 million in institutional assets, is up 1.9% for the first quarter and 7.9% for the year ended March 31, according to Lipper data.
The $1.5 billion Chicago Fireman Annuity and Benefit Fund, Chicago, and the $225 million Covenant Ministries of Benevolence Fund, Chicago, are two pension funds that invest in the Liberty Stein Roe Floating Rate fund.
The Covenant Ministries of Benevolence Fund was one of the first pension funds to invest in the Liberty Stein Roe offering. Philip Melchert, senior vice president and chief financial officer, said 40% of the pension fund's $35 million fixed-income allocation is invested in the Liberty Stein Roe fund. "What we like about it," said Mr. Melchert, "is that it gives us in general a higher yield than we're going to get anywhere else, and it's especially a good deal in times of interest rate increases because it essentially has no duration."
Ultimately, said Mr. Melchert, the key to performance is buying the right loans, which he said the Liberty Stein Roe team has done so far.
Purchasing the "wrong loans" can expose bank loan funds to credit risk, which is what Chauncy Lufkin, portfolio manager of the $2 billion Franklin Floating Rate Trust, manages against.
The fund, offered by Franklin Templeton Inc., San Mateo, Calif., is one of the top performers in the category with a return of 1.7% for the quarter and 8% for the year ended March 31. Mr. Lufkin said this is because the portfolio management team is selective about the loans it buys. "We concentrate the fund in those industries and companies that will hold up no matter what the economy does," said Mr. Lufkin. The heaviest exposure is in cable television, which represents 8.5% of the fund. The top two positions in the fund, which has 220 holdings across 57 industries, are the fourth and fifth largest cable television outlets in the country, Charter Communications and Adelphia. "We're buying it because if there's a slowdown in the economy, the last thing the consumer does is unhook their TV," said Mr. Lufkin.
The Franklin Floating Rate Trust Fund has been around since 1997 but mainly has been marketed to retail investors. However, institutional investors do buy into the fund and represent about 15% of its assets, estimated Mr. Lufkin, who said he hopes to increase the institutional share.
Aside from the Liberty Stein Roe fund, just two other bank loan funds are categorized as straight institutional funds, and both are offered by Eaton Vance Management, Boston. The Eaton Vance Advisor Senior Floating Rate is up 1.5% for the first quarter and 5.9% for the year ended March 31. The Eaton Vance Institutional Senior Floating Rate has gained 1.5% through the first quarter and 6.5% for the year ended March 31.