June 2012
Are the marketing claims made about Bank Loan Funds True? Can they provide protection against rising interest rates and high-yield at the same time? The answer is a QUALIFIED yes.
While the benefits are real, there are several important drawbacks that to consider. What are bank loan mutual funds? They are funds that invest in loans made by banks to corporations with floating interest rates. The interest rates are tied to a measure of short-term term interest rates (for example LIBOR). The loan typically calls for the borrower to pay a variable short-term interest rate, plus a fixed interest rate.
The short-term interest rate component of loans is usually reset every 90 days. Right now, the fixed rate for new bank loans averages around 6.0%. However, the fixed interest rate can be significantly higher or lower depending on the credit status of the borrower. There are two interesting characteristics of bank loans They typically can be re-paid by the borrower at any time without penalty. (This makes them like a bond which is perpetually callable at face value). They are superior to bonds in terms of credit standing.
Assuming that a company has both bonds and bank loans outstanding, the bank loans almost always have stronger legal claim to companies assets in bankruptcy.
Key Concepts To Consider When Rates Rise, Bank Loan Funds Don’t Lose Value.
Yields on bank loans are directly tied to short-term rates. If rates rise, so does the yield being paid on the bank loans. Therefore, rising rates do not result in bank loan mutual funds falling in value. With a typical bond mutual fund, rising interest rates will cause significant losses in a fund’s value. Bank Loan Funds Hold Risky Debt & Have Volatile Performance. According to JP Morgan, the average default rate for the last 20 years is around 4.0%. However, …
