Investors in search of higher yields are increasingly being steered into funds that buy floating rate bank loans. They are pitched as paying 5% with little if any interest rate risk. However, the Financial Industry Regulatory Authority (FINRA) warns that these loans come with significant risks, including potential credit, valuation and liquidity problems.
Thus, contrary to popular belief, bank loan funds are more correlated with the stocks than bonds. In good economic times floating rate loans may gain in value, though not nearly as much as stocks. But in bad economic times, funds of floating rate loans may perform worse than junk bond funds (“A Risky Reach for Yield,” Bloomberg Businessweek). In 2008, bank loan mutual funds lost 30% while junk bond funds lost 26%.
The bank loans are typically made to buyout firms. These firms have a practice of “piling debt on to companies they own to extract payouts,” which “may reduce the credit-worthiness of borrowers and make defaults more likely,” according to the article.
As always, investors and their financial advisors need to carefully assess the risks and the investor’s investment objective and risk tolerance before investing.
Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.