"This is not a risk-free asset class. It's not just a turbo-charged money market [fund]," Bakalar says. Because the loans are unrated and not considered investment-grade, the sector is susceptible to overall credit concerns. By comparison, money market funds invest only in the high-rated, short-term bank debt and guarantee the principle, or the value of each dollar invested, but pay virtually no yield.
Closed-end funds can borrow up to 33 percent of a fund’s assets to boost yield in leverage strategies such as borrowing at a low rate and reinvesting at a higher one. During the financial crisis and the credit freeze, the Senior Income Fund lost about one-third of its value amid concerns over this leverage. In 2011 when the Congressional budget stalemate threatened to shut down the U.S. government's funding, the fund lost about 10 percent of its net asset value in a few weeks, before recovering to gain steadily since.
"It's only during exceptional times like a credit crisis that it happens. It requires a very unusual period of systemic financial risk and concerns about the frailty of bank loans and a massive amount of deleveraging when the babies are thrown out with bath water," Bakalar says. In fact, he adds, the leveraged loan market bounced back strongly, and "you would be well ahead if you had held on to the fund."
The biggest problem now for bank loan funds is that the huge demand for relatively low-risk floating rate issues is not being met with a lot of new supply from borrowers, which could put a lid on the interest rates paid by funds. "Deals are picking up a bit, but it's still not what we would hope," Bakalar says. The demand from issuers wanting to do deals could pick up in a stronger economy, restoring higher yields, he adds.
Todd Rosenbluth, director of ETF research at S&P Capital IQ, says exchange-traded funds have been entering the space amid concerns that the growth in the loan funds could lead to a lowering of credit quality. "Without a rating, it's hard to know the level of risk that's tied to some of these funds," Rosenbluth says.
But he says the overall attractiveness of loan funds right now comes from their ability to pay higher rates as the Fed tightens. "The risk in any individual loan can be partially offset with a large number of them that a fund owns," Rosenbluth says. Because they are classified as bank loans, they are among the first liabilities to be paid off after a default. "They they have a higher level of security than other debt classes like junk bonds, so they are more likely to pay off," Rosenbluth says.
Indeed, when junk bond yields sank below the level of leveraged loan funds, it set off a buying frenzy, since the loan funds now offer higher yields with less risk than bonds.
Bakalar says loan funds are "a market where fund managers can really protect you from the downside." His fund charges a relatively high annual fee of 1.6 percent, but it goes toward a management staff of 25 credit specialists who assess the risk of each issue.
Bank loans have a relatively low historic default rate of a bit over 3 percent, which is lower than unsecured or other subordinated debt. Just as important, Bakalar's ING bank-loan credit team focuses on recovering assets if there is a default. The bank loan fund generally manages to recover 70 cents to 80 cents on the dollar, more than twice the overall recovery rate for junk bonds. "Most of [the ING credit team has] been working together for 12 years," Bakalar says. That's long enough to have been tested by hard times. Since 2008, the Senior Income Fund has jumped from an average to an above-average rating by Morningstar, which now gives it a four-star rating for its 8.5 percent annualized return over the past three years, more than twice its bond benchmark. That experience could help in good times ahead if rates rise as Bakalar expects.