Be Your Own Loan Shark With Bank Loan Funds

By Aaron Levitt | February 12, 2009 AAA

As yields on Treasury bills hover near zero, and financial gurus, including "bond king" Bill Gross, call the securities over-valued and over-priced, income investors find themselves in a quandary. Mitigating risk, while increasing return, is the name of the game in the current market. But, the pursuit of safety currently leads to zero proceeds.

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Bring On The Short-Term Junk
Deals abound for investors willing to ratchet up their risk. The yield spreads of everything from bread-and-butter corporate bonds to municipals are at historical highs against the treasuries. Although spreads have been shrinking as investors increasingly take advantage, some spaces in the credit market still warrant a closer look - specifically, funds that invest in floating rate bank loans.

Simply put, these mutual funds invest in the loans that banks make to corporations. Oftentimes, these companies fall below the investment grade debt ratings of BBB or lower on the S&P and Baa or lower on Moody's. Interest rates on these floating rate loans reset every one to three months, with the lending banks receiving premiums over a chosen benchmark, usually the LIBOR.

While these floating rate funds invest in low grade paper, they have some advantages over standard junk bonds. First, floating rate funds offer diversity. By investing in the sector via funds, investors can spread out single issuer default risk, as each fund owns hundreds of different loans. Second, these debt instruments usually are secured by a company's physical assets, such as a pipeline, warehouses or equipment. Thus, floating rate loans are preferred funding methods for telecoms, utilities and smaller energy companies. (Learn more in Corporate Bonds: An Introduction to Credit Risk.)

However, the most important feature of these loans is seniority in instances of default or bankruptcy. The backbone of the floating rate loan fund is first lien or senior debt, which take precedence over all other claims (save for those initiated by Uncle Sam) and include preferred stocks and even junk bonds issued by the same company. The typical recovery rate for senior notes in bankruptcy is approximately 70 cents to 80 cents on the dollar, compared to an average of 25 cents on the dollar for a straight junk bond.

Skip The Open-End Mutual Funds
The few open-end mutual funds in the sector come with heavy sales loads and a few, due to the nature of the asset class, limit withdrawals to once quarterly. Therefore, the best bang for the buck comes in the form of closed-end funds, which often trade at a discount to their net asset values (NAV) and pay above average dividends due to their leveraged nature.

The ING Prime Rate Trust (NYSE:PPR) has holdings in 329 different senior loans spread across 37 industries, with the largest weighting towards healthcare. The fund trades well, at an average volume of 600,000 shares daily. With recent prices averaging $3.84, the fund yields almost 8.80%. Currently, the fund trades at a slight premium to its NAV, which is within its historical norm.

However, investors who crave more risk can turn to the Van Kampen Senior Income Trust (NYSE:VVR). In mid-2008, 21% of its senior loans were held in unrated assets. Because this fund carries more risk, coupon rates are higher. Its largest sector weighting is in printing and publishing, at 9.74%. The Senior Income Trust trades at a discount to NAV and presently yields nearly 11.5%.

At nearly a 20% premium to its NAV, investors certainly would be seeking guidance from a specialist in PIMCO's Floating Rate Income Fund (NYSE:PFL). With a 27% weighting towards banks and financial institutions, the fund is not for the faint of heart. However, those willing to take the risk are rewarded with a yield of approximately 15%.

Blackrock's Senior High Income Fund (NYSE:ARK) calls itself a bank loan fund, yet it only has about 51% of its holdings in bank loans. The remaining percentage of the fund is made up of everything from asset-backed mortgage securities (1%)and investment grade corporate bonds (2.4%), to a small allocation of common stocks (0.4%). The fund may make an excellent addition for some investors, but as a pure senior loan fund vehicle, it does not have enough muster. The fund currently trades at a 7% premium and yields slightly more than 14%.

Inversely, Nuveen's Senior Income Fund (NYSE:NSL) is what a bank loan fund should be, with 94% of its loan portfolio devoted to first lien loans. The fund also sports a 2% weighting to international dollar denominated loans. While the overseas weighting is currently small, the fund's managers have the ability to increase this weighting to 20%. Presently trading roughly flat to its NAV, with a discount of 1.83%, investors can expect 4 cents per month in distributions for a 13% yield. (We break down the key components of analyzing a fund manager's performance so you can find a winner! Learn more in Choose a Fund With a Winning Manager.)

Bottom Line
Many income seekers flocked to quality, but prices dropped to levels never before seen. As prices reset in the upcoming months, investors can be rewarded handsomely by taking on a little risk. By selecting senior loans and their preference in bankruptcy, investors can take away some of the risk of bond investing. Therefore, the preceding closed-end funds are a great way to participate in the sector.

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