Demand for Loan Funds Grows Despite Risks

According to the Financial Times, last week more money went into mutual funds and exchange traded funds that buy syndicated loans than went into equities.  The article pointed out that there have only been three weeks in the past year that saw a net outflow from the sector, with the most recent outflow in June of last year.  On the face of it, it is easy to understand why funds that invest in loans make sense.  Syndicated loans have floating interest rates, typically tied to the 3-month LIBOR, so an increase in interest rates should not negatively affect the value of the loans.  The loans also pay high yields, which appeals to investors looking for income.  The yield on a typical loan fund can  be as much as 500 basis points above the three-month LIBOR. Investors in these types of loans should keep in mind that, while the funds can protect against interest rate risk, they carry a great deal of credit risk.  If the economy were to weaken, syndicated loan values could be hit hard due to a rise in corporate defaults.  Many syndicated loans are sold to finance leveraged buyouts of heavily indebted companies. In 2008, the value of many loan funds fell by more than 30% compared to investment grade bonds, which were up during the same time period.  So while the hunt for yield in today’s low interest rate environment is understandable, investors need to keep in mind how much risk they are willing and able to take when looking at different investment alternatives.  Our guess would be that, if you asked the average investors who are buying a syndicated loan fund today if they could afford to watch that investment lose 30% of its value, they might think twice about investing in it.