The following article is a guest post. Bank loan funds can be a good investment. They often have fairly high yields with less risk than some other high-yield investments. They can bring some stability to your portfolio as well as bring you the benefits of diversification. But just like any other investment, bank loan funds are not without their risks.
If you’re thinking of investing in bank loan funds, it’s important to understand what they are and what the potential risks are. Some investment professionals advise steering clear of bank loan funds altogether, especially in uncertain markets. But if you know what you’re doing, and you’re willing to assume the risk, bank loan funds can bring a stable rate of returns to your portfolio.
What Are Bank Loan Funds?
A bank loan fund is an investment vehicle that lets investors buy shares of corporate bank loans. Banks and insurance companies may make these loans to companies with less-than-perfect credit, but that in itself isn’t a reason to worry about not getting your money back. More than 80 percent of companies that have defaulted on their bank loans have been able to pay the investors that own shares in these loans. When the economy is doing well, you’re probably not going to need to worry about losing money on bank loan funds. Just like a lot of investments, the losses come when the economy tanks.
Upsides of Bank Loan Funds
One of the best things about bank loan funds is that they offer a higher rate of interest than you’ll get with CDs or savings bonds, but at what many consider to be a comparable level of risk. Bank loan funds offer returns as much as two percent better than those of CDS or Treasury securities. These funds offer floating rates, which change whenever short-term interest rates rise. Every 30, 60, or 90 days, bank loan fund yields will be reset. When interest rates are trending upward, that’s good news for your returns.
Bank loan funds also have a fairly stable share price. Though you might be worried about getting your money back if the company that took out the loan declares bankruptcy, you can rest assured that these funds invest in what are known as senior secured loans, which will be the first ones to be paid back in case the company in question declares bankruptcy. You’ll probably still get your money back even if a company defaults on its loans.
If you choose an investment vehicle such as a bank loan fund, you’re getting a diversified product, just like with a mutual fund. You won’t be buying just one company’s loan, so if one company defaults on its loan, it won’t affect the value of your investment much.
Downsides of Bank Loan Funds
So, what are the cons of investing in bank loan funds? For one thing, the floating rates discussed above can be less of a perk if overall interest rates go down. Furthermore, you can’t take your money in and out of a bank loan fund whenever you want; depending in the rules of the fund you choose, you’ll only be able to make withdrawals at designated times, like monthly, quarterly, or yearly. Many bank loan funds require investors to leave their money in the fund for the first year and there might be fees to pay if you remove your money from the fund within the first three years. Investing in these funds can also be expensive; high expense ratios as compared with bond funds, for example, can really cut into your profits.
Like other investments, bank loan funds are hit hard during times of recession. While returns can be much higher than those of CDs or Treasury securities, they can also be significantly lower. In October 2008, bank loan funds saw returns drop by a whopping 13 percent. That’s a lot, considering an average fluctuation in returns is about 0.5 to 1.5 percent a month.
Bank loan funds also have a liquidity problem. Because the market for bank loan funds hasn’t been around long — about 20 years — there aren’t as many buyers and sellers in the market as there are for some other markets, so it can be hard to liquidate bank loan fund shares. If a bank wanted to sell off a large fund, prices across the industry would drop enormously.
Many investors are wary of bank loan funds, but they can be a good investment if used as part of a diversified portfolio. They’re especially good in prosperous times, but you should be aware that they do tend to drop in value quickly when the market goes down.