For most of the past
decade, bank-loan, or ''prime rate,'' funds have been sweet deals for
income-oriented investors. The funds buy slices of floating-rate loans that
banks make to noninvestment-grade corporate borrowers. The interest rates on
these ''leveraged loans'' average 3.5 percentage points above the London
Interbank Offered Rate (LIBOR), a key bank-to-bank lending rate, and are reset
every three to six months. As a result, investors in these funds have managed
to pick up bond-like yields with minimal fluctuation in the net asset value
(NAV) of their funds.
Now, defaults on bank loans are rising, and credit quality throughout the
economy is deteriorating. The Securities & Exchange Commission is putting
pressure on bank-loan funds to change the method of valuing their portfolios.
That will lead to wider price swings. ''How you're pricing loans is having a
bigger impact on performance, because there are more bad loans out there,''
says Morningstar analyst Sarah Bush.
Given the market, bank-loan funds are having a so-so year (table, page 212E8).
The yields are high--8.2% on average--because short-term interest rates are
high. But NAVs are in a slight decline, so total returns are on average 3.9%.
That's still better than most junk-bond funds.
A bad bank loan isn't quite as bad as, say, a junk bond that fails to make its
interest payments. The loans these funds buy are senior, meaning the debt must
be paid ahead of others, and are secured by assets or other collateral. Junk
bonds are usually unsecured IOUs and subordinate to bank loans. Even in
default, the recovery rate on these loans is about 75 cents to 80 cents on the
dollar, about twice the recovery rate of junk bonds.
In the past, bank loans were a private affair, worked out between the bank and
its client, then carried on the bank's books at face value and held until
maturity. But increasingly, lenders have been selling off pieces of the loans
to mutual funds and other institutional investors, and a secondary market has
evolved. Trading in the secondary-loan market grew from $20.8 billion in 1994
to $110.3 billion in 1999, according to Loan Pricing Corp.
Despite price fluctuations on the secondary market, many funds were still
valuing most of their loans at face value until the SEC issued an interpretive
letter last December ordering them to change their valuation methodology. Loans
that trade in the secondary market must now be priced as they trade, or
''marked to market,'' like stocks and bonds. If a reliable market quote is
unavailable, managers must estimate the ''fair value'' of the asset as if it
were sold today.
The oldest of the bank-loan funds are most wed to the old valuation system and
have been under the most pressure to change: Morgan Stanley Dean Witter Prime
Income Trust, Eaton Vance Prime Rate Reserves, and Van Kampen Prime Rate
Income. Morgan Stanley's fund now prices 44% of its loans by the market,
according to its latest semiannual report. Up until a year ago, none of the
loans was marked to market. Eaton Vance now prices 70% in the market, up from
10% this March. Van Kampen declined to disclose to what extent it is using
market prices in calculating NAV.
Longtime owners of those funds are now experiencing more volatility in NAVs.
''For a long time, the funds would move just pennies a year,'' says Bush. No
more. In nine of the past 10 years, Eaton Vance Prime Rate Reserves never lost
more than 0.4% of NAV. This year its NAV is down 2.3% as of Oct. 18. Van Kampen
Prime Rate Income had not lost more than 0.5% since 1989, until it started
marking to market last year. Its NAV fell 2.3% in 1999 and 4.1% this year.
NO SURPRISES. Some of the volatility comes just from the change in
pricing. But bigger forces are at work. Last year, leveraged loan defaults rose
to 1.94%, the highest level since 1992. Loan Pricing analyst Michael Lavin says
the defaults so far this year suggest that 2000 default rates will be ''on par
with or exceed those seen in 1999.''
Not all funds need to change to marked-to-market. Newer portfolios, such as AIM
Floating Rate and Franklin Floating Rate, have used market prices for daily
valuations since their inceptions. Investors in those portfolios should not be
getting any unusual surprises.
Investor interest in bank-loan funds is growing. In August, Fidelity
Investments launched its first in this category: Fidelity Advisor Floating Rate
High Income. The Fidelity offering is also the first of its kind to allow daily
redemptions. Eaton Vance, which pioneered these funds, came out with a daily
redemption fund in September. Prior to these new entries, most funds allowed
investors to redeem shares just once per quarter.
Even with their greater volatility and credit risk, bank-loan funds can make
sense. Since they behave neither like the stock nor bond market and have a
relatively high yield, they make good diversifiers for any portfolio.
Copyright
2005, by The McGraw-Hill Companies Inc. All rights reserved.
