The thing about bank loan funds

From January through May I had wholesalers from all the big ETF and mutual fund shops in my office pitching us bank loan funds as a diversifier and an interest rate hedge for our income-focused models. State Street rolled one out as an ETF with Blackstone / GSE doing the portfolio management. iShares had one too, then DoubleLine launched one, etc.

Bank loans, in securitized form, tend to offset rising rates because they roll over frequently at ever-higher interest rates to the borrowers. Thus, if you own the interest stream on a portfolio of loans, as rates rise, theoretically, so should the income you’re pulling in. The loans in the portfolio mature and new loans are struck with borrowers at ever-higher rates. And, as Christine Benz at Morningstar explains, they do a really good job at diversifying you as well, with a very negative correlation to long-term treasurys.

But there’s a catch (when is there not?) – bank loans are highly correlated, for a bond asset class anyway, to US stocks. This is a risk-on asset class, after all, and will trade lower based on the threat of defaults picking up across the economy, just like junk bond ETFs will. Eventually.

Here’s Christine:

Bank-loan funds’ correlation with high-quality bond funds is also pretty low. That’s perhaps not surprising when you consider that bank loans are typically beneficiaries when rates rise (their yields tick up to keep pace with LIBOR), whereas high-quality bond funds get hurt. During the past decade, bank-loan funds have exhibited a slightly negative correlation with the Barclays Aggregate Index and an even lower correlation (-0.35) with long-term Treasuries. The 10-year correlation with short-term bonds is higher (0.57) and higher still for equities (0.61) and high-yield bonds (0.87).

Thus, even though bank-loan investments may help mitigate the pain in a rising-rate environment, investors expecting these funds to provide ballast in an equity market shock might not get it here. In 2008, the typical bank-loan fund lost 30% of its value, though higher-quality offerings such asFidelity Floating Rate High Income (FFRHX) held up substantially better.

Like all products, strategies or asset classes, bank loans can work if used appropriately and with the right understanding of their idiosyncrasies and risks. But to just toss them into a portfolio as part of the bond category would be a mistake. There’s nothing bond-like about them in a recessionary environment or during an equity market sell-off. They will not be your safe assets in an economic crisis.

Understand that while you’re mitigating one risk (interest rates), you’re taking on another one.

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