Bank-Loan Funds: A Risky Reach for Yield

With interest rates so low, individual investors have been piling into bank-loan funds, taking on more risk as they seek higher yields and a hedge against inflation. In April $729 million flowed into U.S. mutual funds that invest in the corporate debt, also known as floating-rate loans, according to preliminary data from EPFR Global, a research firm. This year investors added a net $1 billion to the funds through May 2, after pouring in $6.4 billion last year.

The funds buy speculative-grade loans used to finance buyouts. Because their rates are variable, the loans are less vulnerable than fixed-rate investments to increases in interest rates. And they usually offer better yields than high-quality bonds. “Where else can you get 4 percent to 5 percent with zero duration?” says Christopher Remington, institutional portfolio manager for Eaton Vance (EV), which oversees about $24.7 billion in floating-rate loans for individual and institutional investors. Duration is a measure of interest-rate sensitivity.

For Maury Fertig, chief investment officer of money manager Relative Value Partners, bank loans are “a sweet spot right now.” The loans have a chance to gain value as the economic recovery continues, he says, “and in the event of higher rates, I’m not going to lose a tremendous amount of principal.” Bank loans account for about 15 percent of his clients’ fixed-income assets.

The advantages come with significant risks. In times of economic stress, the funds can perform worse than junk bonds. Bank-loan mutual funds lost about 30 percent during 2008, compared with about a 26 percent decline for funds that invested in high-yield bonds, according to data from Morningstar (MORN). “People are so starved for current yield that I think it’s pushing them into spots they otherwise wouldn’t go,” says Mark Balasa, chief investment officer of Balasa Dinverno Foltz, a wealth management firm. “In 2008 these things got shelled.”

The Financial Industry Regulatory Authority in July issued an alert warning investors about purchasing complex products, including floating-rate loan funds. “Funds that invest in floating-rate loans may be marketed as products that are less vulnerable to interest-rate fluctuations and offer inflation protection, when in fact the underlying loans held in the fund are subject to significant credit, valuation, and liquidity risk,” Finra stated.

Investors may not realize that floating-rate loans tend to move more in step with stocks than they do with bonds, says Douglas Anderson, a director with Harris MyCFO, a unit of Bank of Montreal (BMO). “The more you take out of traditional high-quality fixed income, the more exposure you’ll have in the event of a significant market correction,” he says.

Another risk investors may overlook: Buyout firms’ practice of piling debt on to companies they own to extract payouts may reduce the creditworthiness of borrowers and make defaults more likely. SeaWorld Parks & Entertainment, the Orlando-based amusement park operator and home of Shamu, the killer whale, was downgraded by Standard & Poor’s (MHP) after getting a $500 million loan in March to fund a dividend to owner Blackstone Group (BX). S&P lowered SeaWorld’s credit rating to B+, four levels below investment grade, from BB-, because of the increase in leverage following the distribution. “When everyone is concerned about yield and return and growth, rather than risk,” says Joseph Duran, chief executive officer of investment adviser United Capital, “it invariably leads to bad outcomes.”

The bottom line: Investors have poured more than $7 billion into bank-loan mutual funds since the beginning of 2011. Many may not grasp the risks.

Idzelis is a reporter for Bloomberg News in New York. Ody is a reporter for Bloomberg News in New York.

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Risky Banks to Face Scrutiny From U.K. Regulator, Sants Says

May 19, 2011, 11:16 AM EDT By Ben Moshinsky and Scott Hamilton

(Updates with lawyer comment in 11th paragraph.)

May 19 (Bloomberg) -- The Prudential Regulatory Authority plans to crack down on risky U.K. banks when it takes over financial regulation next year, restricting the dividends and bonuses of lenders at an earlier stage.

Lenders considered a risk to financial stability by the PRA, which will take over bank supervision by the end of 2012, will also face limits on leverage until their business stabilizes, the Financial Services Authority said in a statement today.

“This supervisory approach, to be effective, will need to be based on judgment and a forward-looking assessment of risk,” Hector Sants, who will lead the PRA and is the current chief executive officer of the FSA, said in a speech in London today.

Sants has been pledging more “intrusive” regulation since shortly after the start of the global financial crisis. The government is pushing through the biggest shakeup in financial regulation since 1997, scrapping the FSA and handing its supervisory powers to the new regulator within the Bank of England.

The plan would also create a Financial Policy Committee in the central bank to oversee economic stability risks.

“In cases where a firm’s viability is under threat, the PRA will take supervisory action at an early stage to reduce the probability of disorderly failure,” Andrew Bailey, the deputy- CEO of the PRA, said in a speech.

Bank Failure

The new regulator will allow banks to fail and “will not view the failure of an institution in an orderly manner as regulatory failure, but rather as a feature of a properly functioning market,” the FSA said in its statement.

“Clearly the new supervisory process will look at all aspects of each bank’s operations and we feel that the specific reference to bonuses is sadly playing to politicians and the press rather than providing a greater insight into the supervision process,” a Mediobanca SpA analyst said in a note to clients.

The U.K. government provided a 45 billion-pound ($73 billion) bailout to Royal Bank of Scotland Plc in 2008 after it ran up the biggest loss in U.K. corporate history following its acquisition of ABN Amro Holding NV.

Sants said in his speech that part of the reason for the FSA’s failures was that “it never achieved the full support of Parliament and the public.” The PRA must be able to repair those relationships.

Judgmental

“The PRA is prepared to be judgmental and will challenge managers on fundamental aspects of their business," said Ash Saluja, a financial services lawyer at CMS Cameron McKenna LLP in London. ‘‘Unlike the FSA, the new regulator will be able to reach a different view than managers and confront them on the risk involved in their operations."

Sants said the agency needs public support.

‘‘It is vital to its reputation and authority and ultimately its ability to deliver on society’s expectation that the PRA’s powers and statutory obligations are fully understood and supported by society,’’ Sants said.

U.K. banks will also be required to publish more detailed information about their activities to encourage greater market discipline, Bailey said.

‘‘We recognize that management, shareholders, creditors and auditors all play an important role in managing prudential risk,’’ Bailey said. ‘‘To encourage more market discipline, the PRA will seek to publish some regulatory returns, though it will not go so far as to disclose its own supervisory judgments about firms.’’

U.K. Lenders

Bailey last month joined the FSA as the deputy head of its Prudential Business Unit, as well as becoming director of the organization’s division overseeing U.K. lenders.

He will become the deputy head of the PRA, which is proposed to be responsible for regulating all deposit-taking institutions, insurers and investment banks.

Sants said that the PRA would scrutinize firms’ bonus payouts on an ‘‘individual and aggregate level” to make sure that banks that make large payments keep enough capital in reserve to whether crises.

The regulator would examine “total payouts to employees and make sure they aren’t putting at risk the capital position of the institution,” Sants said.

--Editors: Christopher Scinta, Peter Chapman

To contact the reporters on this story: Ben Moshinsky in London at bmoshinsky@bloomberg.net; Scott Hamilton in London at shamilton8@bloomberg.net

To contact the editors responsible for this story: Anthony Aarons at aaarons@bloomberg.net; Craig Stirling at cstirling1@bloomberg.net

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