The Federal Reserve is not ready to move yet, but when it does raise interest rates, bank loan funds will be one of just a handful of investments that are "well-positioned to participate in rising rates," says Jeff Bakalar, who heads ING's loan funds unit that includes the flagship ING Senior Income Fund.
Nearly everyone expects rates to rise, and many investors are shifting positions already, he says. The markets showed how jittery they are over a possible halt in the Fed's easy-money policy this week when a mere mention that the economy is "improving quite a lot" by a Fed official ended a rally in stocks and bonds, pushing them into negative territory. The dollar continued on its recent upturn.
The markets were rattled even though the Fed's Chicago regional bank president, Charles Evans, assured his audience in a speech that no move is imminent. It showed that even a small twist of Fed policy could contort the whole investing landscape. A bigger move – a tightening after five years of easing – could totally reshape it. Chairman Ben Bernanke told Congress Wednesday that the economy is stronger but still needs the help of Fed bond purchases to keep rates low. Few expect any big policy move, yet.
"When it happens, its impact may fall outside of expectations," Bakalar says. "Many investors may not be prepared for the speed and magnitude of the move."
He says it could take a year or more for the Fed to act, but when it does, investors remain so heavily invested in the fixed-income sector that many portfolios could take a hit. Individual bond holdings remain high by historic standards, even after this year's rush to equity. Balanced funds and target-date funds, among the most widely held by individuals, often include high percentages of fixed income, typically 40 percent to 50 percent for those nearing retirement.
Loan funds in demand. Investors are chasing yield wherever they can get it, of course, but bank loans have the added attraction of promising higher yields and holding their value, unlike highly rated bonds, which will lose value when the Fed changes course.
Investors have been piling into bank loan funds like the ING Senior Income Fund at unprecedented rates this year as people start to look for income alternatives outside the more vulnerable fixed-income sector. That's because bank loan funds run counter to the bond market. They are made up entirely of loans whose payments are pegged to bank loan rates, usually LIBOR (the London interbank borrowing rate). The loans that the funds invest in are not backed by the banks, but are packaged and sold to the funds. They are tied mostly to mergers and acquisitions, particularly private equity deals, and are considered speculative or below investment grade. Because of this, loan funds like the ones Bakalar's Senior Income Fund invests in are one of the few asset classes that benefit when rates rise in an expanding economy. Lipper reports that more than $20 billion have been added to floating-rate bank loan funds this year already, more than is invested in a typical year for the little-known sector. Morningstar data shows that over the past year, loan funds have paid returns of between 8 percent and 18 percent.
The floating-rate bank funds could provide an alternative for investors who have fled to the "safety" of equities as a way to avoid bond market losses if the Fed raises rates. The stock market, too, could be vulnerable to downturns if interest rates increase too suddenly. The expected return rates for stocks – as measured by price-to-earnings – tend to reflect any rise in prevailing interest rates. That will put pressure on stock prices as rates rise – at least until corporate profits rise enough to offset rising rates.
Difficult period ahead. "This will be a very, very difficult period for investors," Bakalar says. "It could happen very quickly and be a very hard landing [when the Fed hikes rates.]" Bakalar concedes that the bank loan sector is not immune to market turmoil. Because loan funds are made up of below-investment-grade loans and some of them employ significant amounts of leverage to boost yields, any worries about overall creditworthiness can cause prices to fall precipitously.