One of the Hottest Areas of the Market Starts to Cool

One of the Hottest Areas of the Market Starts to Cool

Caroline Purser/Getty Images

In mid-April, something highly unusual started happening in a corner of the mutual fund universe known as loan participation funds or floating-rate funds.

You may well never have heard of these funds. They make up a relatively small part of the investment grade corporate debt market — and a positively tiny part of the giant mutual fund market. Yet they have become so ubiquitous in the last two or three years that, odds are, a few shares of one of these vehicles lurk somewhere in your portfolio.

Related: Big Disconnect Between Equity and Debt Investors

Here’s what makes them worth noticing now: Up until mid-April, loan participation mutual funds had attracted net new cash from investors for an astonishing 96 straight weeks. That trend has turned, with investors pulling about $1 billion out of these mutual funds and ETFs in the past few weeks.

Loan participation funds invest in loans made by banks and other institutions — but only in floating-rate loans. That shelters investors from interest rate risk: As rates rise, so do the rates on the loans in these funds. Moreover, since loans are typically priced off short-term interest rates (like LIBOR), the movement that we’ve witnessed in longer-term interest rates won’t have much impact on the market, anyway.

Then there’s the question of exposure to credit risk. A company that issues these loans typically isn’t an investment-grade company (if it was, it would likely sell commercial paper, which carries a lower interest rate and is thus less attractive to investors as a result.)

Loans are at the top of the capital structure: A lender gets first claim on any assets in a bankruptcy, restructuring or workout scenario, followed by debt holders. Only then would shareholders collect anything that is left on the table. So a bank loan fund gives you more security than a junk bond fund, theoretically. It also has proved to be less volatile: While junk bond funds have been hit by periods of market jitters and outflows, the bank loan participation funds have moved serenely forward, unrattled.

Regardless of what interest rates were doing, of fears about emerging markets, the Fed’s tapering, China, the Eurozone, Syria, the government shutdown, high yield bonds and even hiccups in the stock market, this tiny slice of the market sailed relatively calmly along, pulling in dollars hand over fist. Until, that is, the middle of April. Since then, according to the most recent data from Lipper, they have witnessed back-to-back weeks of modest outflows.

Those outflows are small scale and probably meaningless in the grand scheme of things. And hey, even a few weeks is not really enough to label a trend. It’s certainly not enough to outweigh the intense yield hunger that has driven all the buying over the last few years.

In the ultra-low interest rate environment since the financial crisis, those with an aversion to stock market risk and volatility have had to stretch for any kind of reasonable rate of return. That’s made the respectable alternative moniker for the junk bond market – the “high-yield” bond market – look increasingly like an oxymoron, as rates of return plunged to levels investors once collected on plain vanilla investment-grade corporate debt.

Loan participation funds helped to fill some of the void. “The category has tripled in size since 2011,” says Sarah Bush, a senior analyst at Morningstar, who tracks the products.

That should be a red flag, Bush says. “Whenever you start seeing such huge flows into any category, it should be a general source of concern,” she explains.

For all their attractions, investments like the DWS Floating Rate Fund (DFRAX) are not free of risk. Indeed, back in 2007, they were favored as a place to take shelter from rising interest rates. Investors who jumped on board the bandwagon came to regret it during the financial crisis when a combination of credit risk and liquidity risk delivered a big blow to returns. The DWS fund alone lost 28 percent that year; the average fund in the category lost 29.7 percent, according to Morningstar data.

“The problem here is that investors are trading one risk for another and not recognizing that they’re getting any risk,” says Bush. “And in these funds, right now, the question is whether yields are high enough that you’re being paid enough for the risk that you are taking.”

The market has been slow to realize it, but loan participation funds are really just another form of high-yield fund, albeit a variant that ranks senior in structure and thus should offer slightly lower yields in exchange for less credit risk. But both are, in many ways, alternatives to taking a plain vanilla approach to the stock market: When equities do well, the values of these assets are likely to hold up. When investors fret about valuation levels — as happened in April — and the interest rate environment is uncertain, the appetite for loan participation funds should diminish. Investors have been expecting rates to rise this year, but the movement across much of the yield curve has defied those predictions.

There’s no fundamental reason to start loathing this category of mutual funds, and there’s no clear signal demanding that you unload your holdings. In light of its astonishing growth in such a short timespan, though, and the history of asset flows moving in one direction for so long, the prudent course is to stop chasing a trend that has clearly reached an end.

These funds aren’t likely to see huge losses in the near future, but it is still worth keeping an eye out for news that could turn a trickle of fund redemptions into something bigger and uglier. Right now, there’s no catalyst for such a move, but Bush says she’s staying alert for one. “After a tenfold increase in a relatively short time, well, you just don’t know how the market would react to redemptions on the same scale.”

Top Reads from The Fiscal Times: