Funds Get Slammed, Investors Eye Bottom of Cycle

Loan-participation funds continue to struggle under historically low LIBOR rates, defaults and write-downs on holdings, but according to investors an improving economic environment and the end of a deteriorating credit cycle offer some hope for the funds. The collective fund values have dropped from $27 billion in November to just over $20 billion last month, according to Lipper data, and there are not really too many positive signs yet, according to Don Cassidy, senior research analyst at Lipper. "I think we may have a few months of difficulty ahead," he added. Managers of the funds have experienced a torrid time for over a year with default problems coexisting with the onset of mark-to-market pricing (LMW, 11/5).

Though the funds posted positive NAV figures for the last three months, Cassidy argues that the funds should at least be beating the LIBOR rate. "I would propose that any fund in the group should have earned 1.75 to 2% in interest alone in the three months and that therefore any total return below this reflects a decline in NAV, meaning more write-downs of portfolio holdings on average. Depending on what particular cutoff in the 1.75-2 range is used, that leaves only the top 4-6 in the list having escaped further damage," Cassidy explained.

Cassidy suggests watching for a rolling three-month period in which nearly all earnings net at least the interest component, which would indicate defaults/write-downs on the holdings have stopped. "The pattern historically in junk bonds has been that defaults do not magically end at the exact time the economy hits bottom." A fund manager attributed the tough market to names such as Global Crossing, but also the volatility of the tower and wireless sectors. The fallout from Enron also affected the market, as investors were fearful of both the possibility of financial engineering and the impact of off-balance sheet investments by other companies, he said.

The hit to the loan-participation funds has occurred against the backdrop of CLO money flooding into the market, changing the composition of the market. "The overall pool of institutional money is not shrinking," said one banker. "The funds are losing influence relative to the structured vehicles though," he noted. "This is changing the style of management in the market," said an investor, who pointed to the CLOs rating-based model approach. "The ratings are all important and this is driving demand for the higher-rated paper. Instead of thinking, is this a good investment, the buyer considers is it good for my model? The CLOs cannot buy unrated or downgraded paper, as the CLOs cannot take too much risk, for fear of breaking the covenants," the investor stated.