Managers of floating-rate funds are bracing themselves for retail investors to exit the loan market this quarter and beyond, as rising defaults and the record low LIBOR rate hit overall loan returns and those investors find loan funds may not be the sure bet they thought they were. Eric Jacobson, a Morningstar analyst, noted over the last year, many of the funds have already seen dramatic redemptions. "This is the worst period in the history [of loan funds], because the default problems coexist with the onset of mark-to-market pricing," he explained. With the development of mark-to-market pricing the true value of loans held is revealed, hitting the Net Asset Value figures and increasing volatility.
This summer the NAV--including depreciation and redemptions -- for the market's loan funds combined was $27 billion. But it dropped more than $1 billion each month for the last four months, and at the end of September, it stood at $23.643 billion, according to Don Cassidy, senior research analyst for Lipper. In the last month the performance has been down on average 1.68%. Some funds have dropped further, for example the Franklin Floating Rate fund is down 2.34%, and the Scudder Investments Scudder Floating Rate is 2.37% down. Eaton Vance's funds are down on average 80 basis points.
Richard Hsu, portfolio manager at Franklin Templeton, said he expects to see redemptions until the economy rebounds. "There is likely to be higher redemption levels than in the past, due to flight to quality from retail funds in this economic environment," he said. "However, as the market recovers, funds could see stronger net inflows, since there is the opportunity for upside." The exceptionally low LIBOR rate is really hurting the loan funds, said one banker, though once the funds ride out the storm and the LIBOR rate rises, the funds will be attractive again.
Geoffrey Bobroff, president of Bobroff Consulting, said he believes the market has not yet seen the peak of redemptions and the real challenge will come from credit quality issues. "None of these loan funds has ever gone through a recession." Some of the funds tended to take on higher risk over the last few years in order to come to market with higher returns, and the market still does not know how they will respond to a recession. The old Eaton Vance and Franklin Templeton funds have good quality paper, he noted, but some of the newer funds built up during a competitive environment contain riskier credits. The funds will have to respond by shortening the maturities and improving credit, but this will lower the coupon, he explained.
But the market is not necessarily spelling doom for the loan funds. Most managers, Hsu included, are keeping more funds parked in cash and investing selectively until the market improves. "The loan funds are still attractive as an asset class," he said, offering a safe haven from stocks and bonds with a higher recovery rate in default scenarios. Any pullback from loan funds is not really affecting the market because few new issue deals are surfacing and savvier institutional money is amply filling any gaps, market players said. Collateralized loan vehicles look for the arbitrage on deals rather than the LIBOR rate, making the current environment relatively positive. Straight institutional money in the form of pension funds can also be in it for the longer-term.