From the September 2007 issue of Wealth Manager Web • Subscribe!

Banking on Loans

These are flush days for bank-loan funds, which hold below-investment-grade debt. With private-equity groups borrowing heavily, fund managers can pick and choose what they will buy. And even if a fund purchases a shaky loan, chances are any losses will be slight. The current annual default rate is 0.44 percent, one of the lowest ever and well below the historical average of 3 percent. Defaults have become minimal because the economy is healthy. In addition, lenders are eager to do deals. So if a borrower is about to default, many lenders are likely to step forward with refinancing offers.

Can the easy times last much longer? Probably not. With interest rates rising, defaults are bound to rise. But the case for owning a bank-loan fund remains solid. The funds have proved to be consistent workhorses. During the decade ending May 31, 2007, the average bank-loan fund returned 5.0 percent annually and never suffered a losing year. In contrast, the average high-yield bond fund returned 5.3 percent during the decade but suffered three losing years.

Bank-loan funds have achieved their record partly because of the sturdiness of their debt structures. The typical loan purchased by a fund is senior secured debt. In the event of a default, the loan is backed by assets, and the funds stand at the front of the creditors' line. Because of the security, the funds rarely suffer big losses from defaults. In contrast, high-yield bonds are often unsecured, and investors can lose their entire holding.

The loan funds are particularly resilient during bond bear markets. Because the loans have adjustable rates, the debts do not act like typical bonds. When interest rates rise, the prices of conventional bonds drop, as investors flee old issues in search of higher yields. But rates of adjustable issues move up along with the changes in general interest rates. So prices of bank loans don't drop when other fixed-income securities may plummet. Because loan funds don't track bonds, the bank loans can be an ideal diversifier for a fixed-income portfolio.

Bank loans can also add a bit of extra yield to investment-grade portfolios. The bank-loan funds typically buy debt that adjusts along with the London Interbank Offered Rate (LIBOR--the rate banks charge each other). Currently LIBOR is about 5.25 percent, and B-rated loans yield about 7.75 percent.

Which bank-loan fund makes the best choice? To find a winner, we turned again to the eight-part screens developed by Donald Trone, chief executive officer of FI360, a consulting firm in Sewickley, Pa. Trone's due-diligence process seeks out funds that are at least three years old and have a minimum of $75 million in assets. At least 80 percent of holdings must be consistent with the category. One- and three-year total returns must exceed category medians, as must five-year results if the fund is that old. Alpha and Sharpe ratios must also top category medians. The expense ratio must fall below the top quartile.

The screens reduced the field from 47 contenders to 14. Top performers included Oppenheimer Senior Floating Rate and Morgan Stanley Prime Income. But we awarded the title to Highland Floating Rate A, which has among the highest five-year returns in the field, as well as strong alpha and Sharpe ratios.

In part, Highland's success can be attributed to size and experience. The company is one of the largest participants in the bank- loan market, overseeing $8 billion in assets--most of it in institutional accounts. Highland's size and clout allow it to grab attractive issues, while smaller investors must stand in line--and sometimes fill only part of their orders.

Highland's chief investment officer Mark Okada was one of the first investors in bank loans, starting 19 years ago--a time when only a handful of institutions followed the field. Today more than 300 major investors participate in the industry. Joe Dougherty, who has a decade of investment experience, assists Okada in running the mutual fund.

Members of a team that includes 98 analysts and managers, the mutual fund portfolio managers sometimes take chances on defaulted loans. Prices of such troubled loans are often severely depressed because many investors shy away from default situations. Mutual funds sometimes steer clear so that they can claim to have a history of few defaults in their portfolios.

Several years ago, the Highland fund bought loans from defaulted utilities. The prices had dropped sharply, but Highland analysts were convinced that the borrowers were still strong. Soon the defaulted companies did recover, and the loan prices rebounded. That resulted in hefty profits for the fund. "We have the manpower that is necessary to analyze each credit and find opportunities that others may miss," says Okada.

To limit risk, the managers stay diversified, holding more than 400 loans from a variety of industries. Recent holdings included loans for Blockbuster Entertainment, United Airlines and Charter Communications, a cable TV company.

While some investors focus on obtaining high yields, Highland always looks for loans that can provide the best total returns. In an ideal situation, the loan will be backed by strong cash flows and solid collateral. The Highland analysts also consider the rights of creditors and whether the borrower has a strong competitive position in its industry. "Once you have purchased a loan, you must monitor it constantly," says Dougherty. "Credit conditions can change all the time."

By picking the right bank loans, Highland can deliver steady returns and solid yields to shareholders. That kind of result can help to anchor a fixed-income portfolio.

Stan Luxenberg (sluxenberg1@nyc.rr.com), Wealth Manager's "Best of Breed" columnist, is a New York-based freelance business writer and a regular contributor to the magazine.

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