Bank-Loan Funds Gain Momentum Ahead of Fed Retreat

Investors were gearing up for interest rate hikes between January 2012 and March 2014, padding the coffers of loan participation funds (also known as bank-loan funds, senior-loan funds, or leveraged-loan funds). Loan participation funds invest in syndicated loans made to below-investment-grade companies and can provide attractive yields. However, the primary attractor of these funds is that they often provide floating rates that adjust at regular intervals (generally every month or quarter), reflecting changes in short-term interest rates (usually based on a common measure such as LIBOR). So, as interest rates rise, so do the yields on these issues. They can provide fixed income portfolios some insulation against rising rates.

After April 2014 interest in floating-rate bonds began to wane as investors started to worry about global economic growth and the Federal Reserve Board’s keeping interest rates at their lowest levels in history. Other countries’ central banks followed suit and even began to toy with negative interest rates to jump-start their economies. Between April 2014 and March 2016 Thomson Reuters Lipper’s Loan Participation Funds classification witnessed massive net redemptions, with total assets under management for the group declining from $112.1 billion to slightly less than $58.2 billion.

As investors now become more worried about an imminent interest rate hike in the U.S. (there is an inverse relationship between yield and the price of a bond), many appear to be turning cautiously to floating-rate instruments such as loan participation funds to hedge their interest-rate risk. While estimated net flows have only just started to turn positive, total net assets have been on the rise because of positive returns from the underlying securities. For the flows week ended August 24, 2016, Loan Participation Funds witnessed its fourth consecutive week of net inflows, attracting some $300 million for the week.

The market is pricing in a 24% probability of a rate hike in September and a 54% chance in December, according to CME’s Fed Watch Tool. As investors worldwide wait with bated breath for Federal Reserve Board Chair Janet Yellen’s comments to glean knowledge of her expectations of near-term rate hikes at the central bank’s annual retreat in Jackson Hole, Wyoming, this afternoon, floating-rate bonds and loan participation funds may gain more attention as the rhetoric around rate hikes increases.