Do Bank Loan Funds Protect Investors from Duration Risk?

 

  Bank Loan Funds (BLF’s) are a mutual fund asset class that buys corporate loans from banks. They have a higher seniority than bonds during bankruptcy so they are sometimes called “senior secured loans”. The big thrill about this asset class is that they allegedly have no duration risk which is the risk of being hurt by rising interest rates, since the contract specifies that the rate is adjustable on a monthly or quarterly basis. Investors worry that rates are too low and could explode upwards, which would damage the value of long term bonds. Thus owning a Note with a monthly adjustable rate would seem to be a way to avoid duration risk. Investors should seek independent financial advice about the hidden subtleties of Bank Loan Funds.

   There are three potential problems, all of which are a bit hypothetical or experimental since today’s zero bound Fed Funds rate has never been so low for so long so we are in an untested new era. The first problem is the “Floor” on these loans is a Libor rate of 1.5%, yet Libor is at 0.2%, thus Libor would have to rise 130 basis points before an investor got a rate increase. If an investor was expecting his yield to immediately adjust he would be disappointed which could lead retail investors selling at discount to get out. The damage because of the floor problem could be roughly one year times 1.3% which is only roughly a 1.3% drop in value to compensate for this problem. Considering the other risks to this asset and to other types of Notes and bonds are much worse then the Floor problem is relatively minor, assuming the Fed raises rates 130 BP in a year instead of doing so extremely slowly over many years.

  The next problem is that the asset class trades off of mid-term bond discount rates giving it a “spread duration” or “effective duration” of 4 years. Thus the marketplace, dominated by institutional professionals feels the real problem is the effective duration and not the floor problem. The risk is that eventually the marketplace will make 7 year bond yields much higher than today and yet the yield earned by the BLF asset class will the low Fed Funds rate. Assuming a discount rate increase of 1.5% and an effective spread of 4 then 1.5 times 4 = 6% loss of principal caused by rising rates, even though the asset class is perceived as being immune to this risk.

  In many ways the price action of individual bank loans is similar to the problem with trading mortgages. They have negative convexity, which is an asymmetric relationship that favors the borrower. If circumstances favor the borrower they can refinance away creating an opportunity cost of a lost source of revenue for the lender but if it is best for a borrower to stay then no windfall accrues to the lender.

  The third problem is that the individual loans can vary in credit quality with one company getting better and refinancing the old loan away into a low yielding “A” paper loan at another bank, while another borrower gets sick and degrades in credit quality even if the economy is doing fine. A two security portfolio could find on average the credit quality was stable but if half was improving and refinancing away to another bank and the other half of the portfolio was degrading and staying at the original bank and getting downgraded in value then a disproportionate amount of decline of value would be shouldered by the bank even though the economy was OK. Of course banks try to avoid lending to shaky borrowers, but unforeseen events can hurt a borrower later.

  The Bank Loan Fund asset class is less aggressively underwritten than junk bond loans because it comes from the conservative corporate culture of a bank.  I don’t expect some horrible outcome to occur, however, investors need to realize that investing in bonds or Notes has subtle risks that the typical retail investor never thinks about. Before getting carried away with enthusiasm about the allegedly near zero duration risk in Bank Loan Funds one should carefully weigh the possibilities.

   Possible alternatives include a junk bond with short duration and in the high end of junk credit quality which would be a “BB” rating, and owned in the form of using mutual funds that imply in their literature that they are more risk adverse than their peer group. This means putting up with low yields to avoid the potential risk of being ambushed by hidden duration risk and asymmetric credit quality change risk. This is a case where independent financial advice is needed to try to understand the subtleties of mutual funds and this asset class.

About the author

Don Martin, CFP®

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