Ratings

Speculative-grade loans with ratings in the 'B' and 'BB' ranges account for the vast majority of assets in bank loan funds, with a substantial minority of loans not rated at all, and a scattering in the 'B', 'C', and 'D' categories. In the S&P/LSTA Leveraged Loan Index, a widely used benchmark for bank loan funds, 42.1% of the loans are rated 'B', 35.7% are rated 'BB', and 15.9% are not rated at all. A scant 1.2% have an investment-grade rating of 'BBB'. At the other end of the spectrum, 1.8% are rated 'CCC', and 3.2% are at 'D'. At first blush, this mix makes bank loan funds appear rather risky. But several characteristics—covenants, capital structure, and collateral—help mitigate loses from defaults.

Covenants add protection by addressing companies' fiscal responsibility. They mandate standards for dividend disbursements, debt coverage, and net worth, for example; impose limits in areas such as borrowing and provisions on asset sales; and establish ratios for current assets to current liabilities and maximum leverage. If a default should occur, the loans' senior secured status gives their holders payment priority over investors with equity stakes and over unsecured creditors, and the collateral backing up the loans could also be sold to improve recovery even more.

Because of their floating-rate loans, bank loan funds will likely demonstrate less volatility of returns in any interest rate environment compared to traditional fixed-income funds. This is true whether the more traditional funds contain high-quality corporate securities or high-yield speculative-grade bonds. A historical review supports this perspective. So even if defaults increase or the interest rate changes, bank loan funds will probably not experience the amplified return volatility investors would see in fixed-income funds. Chart 1 illustrates this point, comparing the return volatility of the S&P/LSTA Leveraged Loan Index to the Lehman Aggregate Index for the one-year period ended April 30, 2006.

Returns on the leveraged loans adjust at each quarterly resetting of the LIBOR base, which addresses interest rate risk. The spreads over LIBOR factor in credit exposure. For the first quarter of 2006, loan spreads over LIBOR in the S&P/LSTA index ranged from 150 to 350 basis points (bps), with an average of 249 bps. In 2005, the average spread was 263 bps, and in 2004 it was 300 bps.

"In general, we've seen a tightening of spreads," notes Mr. Kerin. "But they could widen out again if defaults begin rising, or if interest rates end their climb."

An excess of capital, both domestic and foreign, has stoked the demand for investments in general and the search for incremental returns. (See "Leveraged Loans: White Hot Liquidity, Red Hot Risk," published April 24, 2006, on RatingsDirect.) This imbalance in supply and demand has created opportunities for lower-grade credits, bolstering both primary and secondary markets. Bank loan funds have benefited from this situation.

But Mr. Bavaria sees this as an overheated market that could be headed for a correction. "There's so much money out there to be invested that some lower-grade credits may be getting a better investor reception than they deserve. Spreads have narrowed to historic levels, and credit standards have deteriorated," he observes. Although he notes that a consensus of opinion predicts the bank loan market will stay on course for another year or so, the big question is when the pullback will occur and lenders start tightening their credit standards. "When this happens," he says, "prices will drop, and spreads will widen on leveraged loans."

So far, though, this hasn't happened. On the contrary, defaults have steadily declined over the past few years, reaching historic lows of late. According to Standard & Poor's Global Fixed Income Research group, the global corporate default rate inched down to 0.33% at the end of the first quarter in 2006 from 0.35% at year-end 2005. Only six companies defaulted in the first quarter this year, compared to nine in the fourth quarter of 2005.

A narrower global focus on speculative-grade default rates, which are more relevant to bank loan funds, shows a higher percentage, which is understandable given the heightened risk. As of May 31, the speculative-grade default rate was 1.09%, but it still represents a 20-year low. This number sends an upbeat signal, since for 28 consecutive months the global speculative default rate has remained well below the long-term average of 4.66% (for 1981 through 2005).

A review of potential downgrades, though, tells a very different story. The number of companies at risk for lower credit ratings jumped to a record high of 663 in mid-April. Although it declined nominally to 657 in mid-May, it's still well ahead of the 620 at the beginning of the year. The April figure marks the highest point for potential downgrades since Standard & Poor's began reporting on them in September 2005.

If the tide turns and corporate downgrades start increasing, followed by rising defaults, bank loan funds will feel the effects. Some investors will likely want out, which will exert downward pressure on prices. At the same time, spreads will widen to compensate for the greater risk. With telecommunications and automotive cited as the sectors most vulnerable to downgrades, the increased risk could exacerbate negative investor perceptions of bank loan funds, which include 'B' and 'BB' rated loans from these companies.

To date, the default history of bank loans appears somewhat erratic. Standard & Poor's Leveraged Commentary and Data group has tracked 2,249 institutional issuers filing publicly since 1995. In 2004, nine loans defaulted for a total of $2.15 billion. In 2005, the number rose just a bit, to 10, but the value soared, more than doubling to $5.38 billion. Through the first quarter of 2006, one loan, valued at $585 million, defaulted.

Moving in the wrong direction, the average recovery rate for bank loans is not encouraging. In 2004 it stood at 51.9%, and in 2005 it declined to 45.6%. It experienced an even sharper drop in the first quarter of 2006, slumping to 36.2%.

Referring to Standard & Poor's recovery ratings assigned over the past few weeks, Mr. Bavaria notes that they've been better than those assigned in recent months, which indicates loan structure and security are improving. "Perhaps the market is already beginning its long-awaited pullback as investors insist on better-structured deals," he says, although it's really too early to tell.

In terms of historical returns, bank loan funds fall between ultrashort bond and short-term government funds on one side and high-yield and long-term corporate bond funds on the other. Using Morningstar data, chart 2 shows bank loan funds have outperformed their short-term government fund counterparts over the past one, three, and five years, and they've bested long-term bond funds for the past one and three years. But their returns lag high-yield funds over that time frame. As expected, these results essentially confirm the classic concept that greater risk results in better returns, provided the investments avoid the ultimate risk of default.

"The biggest challenge for bank loan fund managers now is to avoid loans likely to default," emphasizes Mr. Kerin. A good credit staff will use bottom-up fundamental credit analysis to find those loans least likely to default or most likely to have a high recovery rate. "But even the best managers will likely have a few loans that default," Mr. Kerin added, "so recovery rates play a crucial role at this point. A higher recovery rate may limit negative effects on returns."

The liquidity of bank loan funds also factors into their risk level, and investors need to take it into consideration. Most funds currently offer only quarterly redemptions, which makes them considerably less liquid than more traditional fixed-income and equity investments. If loan defaults rise, liquidity could become a problem.

Some bank loan funds have tried to move to more frequent redemptions, many on a monthly basis and even a few on a daily basis. While some funds can build up their cash balances to meet more frequent redemptions, observers question whether the secondary loan market is really robust enough to support this trend, especially for funds trying to do it on a daily basis. Increasing the frequency of redemption could itself create liquidity problems.

By investing in loans with interest rates that reset every quarter, bank loan funds offer investors less return volatility than more traditional fixed-income funds. The structural safeguards of the loans—covenant protection, position in the capital structure, and collateral—are designed to reduce the credit risk of the funds as well. Given the uncertainty about the longer-term direction of interest rates, in addition to the potential for rising downgrades and ultimately defaults, muted return volatility and extra credit protection are more important than ever.

By Libby Bruch