More institutions look at bank loan strategies

Institutional investors have begun nibbling at bank loan strategies, but their ranks could grow rapidly if interest rates rise.

With the yields on the loans held for those strategies reset every quarter to reflect short-term interest-rate movements, more tax-exempt investors are giving the segment a look as they anticipate damage to their broader fixed-income portfolios when rock-bottom rates finally begin a sustained rise.

Trends are “certainly moving in a meaningfully positive direction,” said Gregory Stoeckle, a managing director and head of the New York-based global bank loan team at Invesco Ltd. which oversees more than $13 billion in institutional bank loan assets.

The number of institutional dollars awarded to bank loan managers during the first quarter of 2011 appears to be almost 50% higher than a year earlier, as more investors look to hedge the risk of rising rates, Mr. Stoeckle said.

Institutional investors pulling the trigger in the first quarter included the $7.2 billion Delaware Public Employees Retirement System, Dover, and the $1.5 billion Arlington County Employees Retirement System, Arlington, Va.

The board of the Delaware pension fund voted to shift $150 million to the T. Rowe Price Institutional Floating Rate fund from a Mellon aggregate bond index fund, according to minutes of the board's Jan. 28 meeting. David C. Craik, state pension administrator, couldn't be reached for comment.

The Arlington County board approved plans to trim the system's S&P 500 index exposure by $50 million and shift that money into the same T. Rowe Price fund.

Daniel Zito, executive director of the Arlington County plan, said his board was looking to trim equity exposure following the market's strong gains, and given the risk-reward trade-offs the system's portfolio is facing now under a variety of economic scenarios, bank loans appeared attractive relative to other fixed-income investments.

Justin Gerbereux, a bank loan portfolio manager with T. Rowe Price Inc., Baltimore, said the number of bank loan-focused requests for proposals and requests for information his team has seen during the first quarter of 2011 is roughly equal to the combined total for the previous two years. T. Rowe manages $1.4 billion in bank loan strategies.

That pickup in interest over the past three to six months reflects the view that the economy has recovered sufficiently to take the risk of deflation off the table, noted Martin Jaugietis, a senior consultant with Seattle-based Russell Investments.

Highly levered collateralized loan obligations were the principal buyers of bank loans in the run-up to the financial crisis, but the next few years could prove to be the first time unlevered investors — including pension funds — dominate the market, predicted Joseph P. Lynch, a managing director and bank loan portfolio manager with Neuberger Berman LLC, New York.

Institutional investors account for $4 billion of the $4.2 billion in Neuberger's bank loan strategy, Mr. Lynch said.

For now, however, that dominance is more promise than fact, with interest-rate movements likely to be the deciding factor.

“How much you think rates are going to rise,” and how quickly, will go a long way toward determining if and when that growing interest in bank loans translates into mandates, Mr. Jaugietis said. He said Russell doesn't see much risk of rates rising more than another 50 basis points for the rest of 2011.

With a fairly steep yield curve now, interest rates would have to rise fairly quickly for institutional investors to enjoy near-term gains from investments in bank loans, and that's unlikely, agreed Eric Petroff, director of research with Seattle-based investment consultant Wurts & Associates Inc.

Craig Russ, a vice president and bank loan team portfolio manager with Eaton Vance Management, Boston, said a growing number of institutional investors he's chatting with now seem to be focusing on timing. With investors clipping coupons of 7% or so from a high-yield allocation and looking at 4% or so from a bank loan allocation, there's some incentive to wait as long as possible before making a switch, he noted.

Eaton Vance manages $9.7 billion in bank loan strategies for institutions, according to spokeswoman Robyn Tice.

Still, money managers say the logic driving institutional investors to consider bank loans now remains compelling.

“Every investor we speak to is concerned that interest rates are going to move,” Invesco's Mr. Stoeckle said. “You don't want to be long duration when that happens.”

Rates were falling in 2009 and economic uncertainty made fear of defaults a concern. Now, however, corporate balance sheets appear as strong as they've ever been, the economy is picking up steam and all that's left before bank loans are firing “on all cylinders” is for interest rates to trend higher, said T. Rowe's Mr. Gerbereux.