Bank loan funds require caution, not blind buying

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Investors tired of trying their luck with the same old securities – equities, corporate debt, junk bonds – are flocking in droves to an alternative option: bank loan funds.

Much like high-yield debt, these funds offer the chance to earn big returns by taking bets on risky companies. But unlike bonds, where investors buy debt sold by a specific company, these funds' underlying securities are bank loans that financial institutions sell to the public markets.

Investors suddenly can't get enough of them. The five largest monthly inflows ever recorded came consecutively from February to June, according to Morningstar Inc.

In part that's because these loans come with variable coupons. Unlike traditional high-yield debt, which typically carries a fixed coupon, these loans are floating rate instruments whose interest payments change when rates rise and fall.

For that reason they are often referred to as floating rate loans, and that very name is something John Carswell at Canso Investment Counsel can't stand. "In retail circles, floating rate has become synonymous with leveraged bank loans." Yet they couldn't be more opposite, he said on a recent conference call with investors.

Floating rate bonds have been around forever and most are sold by relatively safe issuers, such as General Electric Co. The new bank loans everyone wants a piece of are loans made to highly levered issuers "that the banks themselves don't want to own," he said.

"We have seen a number of bank loan deals which we just couldn't believe would be marketed, and were hugely oversubscribed." (He didn't name names.)

Mr. Carswell is worried that investors have no idea what they're buying when they invest in floating rate funds – and that's especially worrisome because you can easily buy some exchange-traded funds that invest in these securities.

His one particular pet peeve with these investments: a slew of bank loans sold into these funds are made to companies with extremely weak credit ratings. Often, these companies are owned by private equity firms who simply take out the loans to pay themselves a special dividend before the company goes bust.

"We've never seen a more stupid or incestuous market in our life than the bank loan market," he said – though he was probably a bit heated and forgot about the subprime mortgage that almost sunk the global financial system in 2008.

The upside, at least, is that Canadian investors are relatively insulated from the mess. Canadian issuers are much more tame, he said, and the big name investors here know what they're doing.

"The U.S.-dollar bank loan market is not for the faint of heart," he said.

(Tim Kiladze is a Globe and Mail banking reporter.)

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