Can Bank Loan Funds Rise to the Top Again?

For many bond fund investors, bank loan funds provided shelter from the storm while the Federal Reserve raised interest rates. Now that rates are coming down, these funds are lagging the broader market. However, one specialist still sees opportunities in the sector. The main reason: Yields remain high enough that they make an attractive proposition.

“Our view is ‘Fed cut, so what?’ You’re starting at such a high absolute yield that you have a substantial cushion for any bumps in the road that might be forthcoming,” says Chris Remington, head of fixed-income products and portfolio strategy at Morgan Stanley Investment Management. Take the $5.6 billion Eaton Vance Floating Rate Advantage Fund EIFAX, managed by a team from Remington’s department. The top-performing fund has an SEC yield of about 9%, depending on the share class.

Bank loan funds, also known as floating-rate funds, returned 5.3% annually over the past three years, more than any other major bond category. They’ve fallen behind as the Fed cut rates in September, returning 2% in the third quarter, well behind most other categories of bonds.

What Is a Floating-Rate Bond Fund?

Floating-rate funds, also often called bank loans or leveraged-loan funds, invest in fixed-income assets whose interest rates are based on a set premium above a particular benchmark. This benchmark is often the secure overnight financing rate (usually abbreviated as SOFR), the interest rate at which financial institutions borrow cash overnight using treasuries as collateral. This means that as the interest rate changes, so does the floating-rate asset’s rate of interest. Because of this, the assets’ price sensitivity to interest rate movements is effectively negligible.

The main floating-rate assets are bank loans, which are given to companies as an alternative to those firms issuing bonds. Unlike high-yield bonds, these loans are secured by collateral in the form of a company’s assets. They are higher in the capital structure, meaning they are paid before high-yield bonds in the event of default.

Funds in this category also hold collateralized debt obligations, or CLOs, which are groups of loans packaged and sold as securities divided into risk-based segments called tranches. The process of collecting a basket of assets and selling it (or portions of it) as new securities is called securitization.

Eaton Vance Floating Rate Advantage invests in bank loans and CLOs. It’s in the top 1% of funds in its category by both 10- and 15-year total return. Floating-rate loans make up 88% of its portfolio with the remainder made up of traditional corporate bonds, CLOs, and cash, according to Eaton Vance.

Has the Bond Market Priced in Rate Cuts?

As rates fall, floating-rate assets’ insensitivity to them becomes a liability, since the prices of existing fixed-income assets rise. “The bond market has had an extraordinary performance over the last month or two,” says Remington. However, with bond prices having shot up since the Fed cut rates, he believes the cuts are priced into bonds, which he thinks may have even overshot.

“It’s all priced in, all those cuts and then some. So that leaves less potential for strong bond market returns ahead,” he explains. “Longer-term rates are likely to rise because they’ve fallen too much, and that will weigh on bond returns, not help them, over the next couple of years. So you want to be underweight duration.”

Remington also highlights that falling rates will help increase firms’ ability to service their debt, creating less credit risk. He says that over the past couple of years, multiple factors lined up to boost the performance of floating-rate debt as rising rates pushed up yields, but the economy stayed strong, so there wasn’t a drop in prices as people fled to safer investments.

He sees particular value among CLOs, which he believes offer comparatively attractive yields for their level of risk. He mentions that they currently have yields equal to those of underlying loans of lower credit quality, or significantly higher yields for the same credit risk. Remington sees opportunities in a variety of sectors, from software to healthcare to industrials. “We think the biggest thing is to diversify and to thin out the risk, so we’re not taking any big risks individually,” he says.

Changing Dynamics in a High-Yield Market

Remington thinks another factor that may help bank loan funds is a change in the dynamics of the high-yield bond and bank loan markets. Historically, such bonds offered higher yields because those assets were considered to have more credit risk. “It’s been the phenomenon over the last five years, you had fallen angels dropping into the high-yield market. Those are [formerly] investment-grade companies that improved the quality of the high-yield market. You also had some riskier junk companies default and leave the high-yield market,” he explains.

High yield bonds, as measured by the Morningstar US High-Yield Bond Index have had a higher rate of return on average than bank loans, as measured by the Morningstar LSTA US Leveraged Loan Index over the past 10-15 years. Remington says that was because high-yield bonds carried more credit risk, but now bank loan funds are the riskier, higher-yielding asset. This means that despite declining due to lower interest rates, bank loans offer very high yields. “Our yields are coming down, and my retort is, yes, but it’s still higher than everything else,” Remington says.