June 29, 2013

A Surprising Opportunity for Possible Yield

Bank loan funds have ‘no upside,’ says Highland’s Okada, so why are they so appealing?

Even as markets deal with the infantile reaction to Ben Bernanke’s awkward comments about the end of QE, one thing is clear: The economy, however shaky, continues to improve.

And despite record bond fund outflows and high-profile hemorrhaging at famous equity firms, bank loan funds continue to thrive. Investors poured nearly $15 billion into bank loan mutual funds in the first quarter of 2013, according to Morningstar. 

Mark Okada“There are two reasons you’re hearing about them,” says Mark Okada (left), chief investment officer of Highland Capital and portfolio manager for the Highland Floating Rate Opportunities Fund (HFRAX). “The first is ongoing concern about monetary policy and interest rate risk across the portfolio. The second is that in an improving economy, investors need access to that economy, and it’s something the asset class offers.”

As to the former, Okada says it protects against downside risk from interest rates. Short-term rates are “not going up anytime soon,” he argues, meaning attendant coupons won’t rise, either. And when long-term rates begin to rise, the asset class typically outperforms fixed income.

As to the latter, because it’s below-investment-grade debt, it depends on the health of the underlying issuer, the particular industry and, hence, the overall economy. Below investment grade also translates to bigger spreads and more room for investors to maneuver, Okada adds.

“As the economy improves, they’re getting a credit spread that’s built into the asset class. So why is the asset class good?” he rhetorically asks. “How else can you get access to the improving economy? Equities are volatile; high-yield bonds have a spread premium, but it’s low and it’s largely offset by interest rate risk. Bank loan funds take interest rate risk off the table and don’t have the volatility of equities, high-yield bonds and certainly not emerging-market debt.”

Okada notes that surprisingly, “there’s no upside in bank loan funds.” Value comes from a return of principal plus the coupon, so the key is to identify problems before they happen (which is pretty much every manager’s objective and easier said than done).

 “What we’ve learned is that if a credit analyst is covering less than 30 issues, they know those issues and are on top of them,” he says. “It’s counterintuitive, but we add alpha and beat the market because we sell better than anybody else, rather than looking to buy at the right time.”

The key is those 30 issues. Many more and the only thing the investor captures is downside risk.

“At a certain point, diversification is not your friend,” Okada concludes. “You might not believe it, but a concentrated portfolio is actually less risky because it’s about better issues, not more issues."

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Check out FINRA Whacks Wells Fargo, Merrill Lynch $5M Over Unsuitable Floating-Rate Bank Loan Funds on AdvisorOne.

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