Last updated: February 6, 2013 7:50 pm

Bank loans pitch faces investor road test

Judged by the sales pitch, loans are a magic bullet. Bond prices will fall if interest rates start to rise, but investing in bank loans can provide a growing income.

“Loans are the anti-bond. They are fixed income in reverse: as rates rise, income goes up,” says Christopher Remington, a portfolio manager for Eaton Vance. He says loans have been snapped up for diversification by customers who have “core bond funds coming out of their eyeballs”.

Bank loan funds

Bank loan funds

Indeed, for investors wary of a return to stocks, but starting to worry that the 30-year bull market for bonds is coming to an end, loans are pitched as the perfect product compared with safe corporate and government debt that will post losses as interest rates rise.

Prodded by such a sales pitch, retail investors are taking notice. In January alone investors poured more than $3bn into mutual funds investing in bank loans, according to Lipper, a research group. The loans are taken out by companies, often to fund leveraged buyouts, mergers and acquisitions, or share repurchases.

From just $12bn in assets at the end of 2008, those US loan funds now hold more than $76bn. Retail and institutional investors have also ploughed money into the leveraged loan market in the past year via exchange traded funds . The PowerShares Senior Loan ETF from Invesco has doubled in size in less than four months, and now has $1.9bn in assets under management.

Part of the attraction is a yield of 6.12 per cent, according to the JPMorgan leveraged loan index, similar to that of its sister market, high-yield debt. But in terms of credit risk, bank loans are a more secure form of lending than buying bonds – investors get repaid sooner in the event of any bankruptcy.

Up close, there are important differences between the structure of the loan market and junk bonds, however. Bonds paying a fixed rate of interest rise in value as interest rates fall, and high-yield borrowers usually pay a premium to call them back, paying off the bonds early as they refinance.

Loans, by contrast, are callable at par or just above, and so as a result do not trade above 100 cents on the dollar. Thomas Lapointe, a portfolio manager at Third Avenue who has the freedom to invest in both high-yield bonds and loans, says: “When you buy something at par, your only option is to lose money if something goes wrong.”

Investors may be happy with that. Arthur Steinmetz, chief investment officer for OppenheimerFunds, says investors accept lower yields for the seniority that loans offer, and the minimal interest rate risk. “You would be protected when interest rates rise,” he says.

Yet another quirk of the market is that, due to short-term rates being near zero, investors will have to wait some time to feel the benefit of any rise in interest rates.

Loans are priced as a spread over Libor, the daily interest rate determined by the price at which banks lend to each other. But about three-quarters of loans issued in the past three years have a so-called “Libor floor” of 110 basis points or more.

So investors will not actually see their coupon rise for most loans until interest rates have risen considerably, to above that floor. “Consider Libor floors as a downpayment on interest rate rises to come,” says Mr Remington.

The problem is that if the Federal Reserve has started to push up short-term interest rates, it probably means the economy is improving. While investors wait to get their higher interest rate, borrowers will take advantage of better credit terms to refinance.

“If history is any guide, the Fed will act late, after the economy is really rolling. By that point, credit spreads will have tightened and your bank loans will have been called away from you at par,” says Mr Lapointe.

He is choosing to invest in high yield rather than loans, where investors will see the benefit of improving credit conditions, and are paid a better interest rate at the same time.

Of course, the economy could get worse, in which case loans will fare less badly than junk bonds. But then an investor would be better off sticking to the safety of quality corporate bonds and government debt.

Mr Lapointe says: “At some point it’s going to be good to be in loans. Well, it isn’t now, and it’s not likely to be for the next couple of years.”

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