Hidden Risks With Bank Loan Funds

Wall Street and mutual fund companies have been pushing bank loan funds as a solution to your fears over inflation. But will bank loan funds provide higher interest payments as suggested, or could they backfire just when you need them?

In general, bank loan funds are being marketed aggressively because of the prospect of rising income payments from the funds. Essentially, bank loan funds are made up of loans from banks to private businesses. But instead of being a fixed rate loan, like 4% for 10 years, the companies that borrow the money have to pay a floating interest rate. That means if rates rise, these borrowers have to pay more interest. And that interest would flow through to the investors in the fund. That's why they're being marketed as a way to protect yourself against the threat of inflation. If rates go up, you stand to get more interest.

That all sounds good, but let's think through this sales pitch.

First, the companies that are the borrowers in the bank loan funds are generally below investment grade, meaning that they're poor credit risks. They're similar to being a "sub-prime" borrower in the world of business. They often borrow from these banks on floating rates because they can't get competitive fixed rate loans.

• Think about it. With interest rates so low, if you were a company, wouldn't you rather lock-in a low interest rate on a fixed rate loan. Why run the risk of borrowing on a floating rate loan if the odds are your interest costs will go up in the future? It just makes it harder to pay back the loan.
• Most strong borrowers are locking-in low interest rate loans for longer periods, just like many individuals have done by refinancing their 30 year mortgages as rates have fallen.

Now here's the second part of the analysis, which I don't see discussed much with bank loan funds. If interest rates go up, that means companies with floating rate loans will need to use more of their cash flow to pay their loans.

• It's like carrying a large credit card balance and then having the credit card company raise the rate on you.

These companies in general are already in a weak financial position, and don't have a lot of extra cash flow to pay their bills. Rising interest rates will make it harder for them to stay in business. Plus, if rates rise, that may cause the economy to slow and could kick us into another recession. Then you could be facing a situation where you've loaned money to companies who can't generate much more revenue because the economy is slowing, but their interest expense is going up because rates are rising. That creates a higher risk that these companies may default on their bank loans. If that happens, you may not see all those rising interest payments you thought you'd get from your bank loan fund.

So before you jump into a bank loan fund, think through the financial analysis on more than one front. Ultimately, the result you get from any loan is based on the ability of the borrower to meet its repayment obligations. Weak borrowers facing rising interest payments would make me nervous about the prospects of getting my money back.

• If you're interested in a bank loan fund, you'll have to do your own investigation on that specific fund because funds have different credit profiles for the loans they place in the fund. And I'm not taking any position on whether they'll perform as described. Some people feel they will. I'm more skeptical.

Bottom line. Bank loan funds offer the prospect of higher interest payments, but you have to consider the odds of getting those payments.

Above material does not constitute investment advice, is provided in summary format, and does not constitute a complete analysis of the issues. Consult your individual financial advisor prior to making any financial decisions.
Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.

Disclaimer: The copyright of this article belongs to the original author. Reposting this article is solely for the purpose of information dissemination and does not constitute any investment advice. If there is any infringement, please contact us immediately. We will make corrections or deletions as necessary. Thank you.