Portfolio Management 101 > Mutual Funds

Should Your Bond Allocations Follow Bill Gross to Janus?

Bill Gross

A week ago Friday, the investment world was shocked when Bill Gross, the venerable bond manager, known as the King of Bonds, announced he was leaving the firm he founded and heading to Janus. Not only is it unusual for the founder of a firm to leave abruptly as he did, but to go to a shop that is not known for its fixed income funds? The whole situation was odd, to say the least.

For the last week, investors have been evaluating their options and trying to figure out whether to stay with PIMCO, or take their money elsewhere. These are big money investors so naturally, the risk of heavy outflows from the fund are a major concern for all other investors in the fund. And liquidity issues that may arise from possibly being the biggest seller of certain financial assets could affect the net asset value of the fund in the short term.

Bank Loan ETFs May Be Good Investments, But Beware of Liquidity Risks

Hidden Risks Ahead

 

There are good reasons why investors should take a long hard look at Senior Bank Loans as a fixed income investment choice in an environment where interest rates are certain to rise.

  1. Most if not all senior loans are structured with floating rates, so that as interest rates rise, the coupon they pay will rise also.
  2. Senior bank loans are exactly where the name implies they lie on the capital structure of a company. They are usually the most senior claim after accounts payable.
  3. The correlation of senior bank loans to other fixed income securities tends to be low. This may be because of the lack of an exchange trading mechanism that adjust price continuously, but the fact of the matter is that correlations are low.
  4. Because the borrower is rated below investment grade, in most cases, the coupon paid on these loans tends to be higher than on comparable floating rate, higher credit quality bonds.
  5. These loans tend to be short-term in nature, so in addition to the higher coupon rates and floating rate nature that minimizes duration risk, the short-term maturities may make it easier to evaluate the credit risk of the company issuing the loan.

But as an individual investor, you may find it difficult to invest directly in bank loans. They are not traded on an exchange so you can’t really enter an order in your Ameritrade account. So the options available are to invest in them through either mutual funds or ETFs.

What to Watch out for in Bank Loan ETFs and Mutual Funds

There are arguments in the financial media for both advantages and disadvantages of bank loan ETF’s. The advantages include low cost exposure, diversification, and liquidity. While some of the disadvantages are lack of fundamental analysis (passive investing) and a mismatch between the liquidity of the bank loans and that of the ETF.

Trade settlement on bank loans can take as long as two to three weeks while ETF’s can be redeemed daily. This creates a risky mismatch in the event of a sudden outflow of funds caused by investor panic attacks. (Not too uncommon) In the event that redemptions occur at a faster rate than positions can be liquidated, investors may not receive less than the value of the portfolio.

The largest bank loan ETF is the PowerShares Senior Loan Portfolio (BKLN) with almost $7 billion in AUM, mimics an index, The S&P LSTA US Leveraged Loan 100 Index. This index is designed to reflect the performance of the largest facilities in the leveraged loan market, not necessarily the most attractive based on fundamental metrics, but probably the most liquid. So investors choosing to invest in BKLN may have less risk of a liquidity mismatch but not necessarily the best bank loan funds.

Finally, despite being heralded as good hedges against rising interest rates, most bank loans have a LIBOR floor. With LIBOR hovering at such low levels, the initial reaction of coupons on bank loans may be somewhat muted until LIBOR surpasses the floor at which interest rates begin to adjust. For example, if bank loans have a coupon of LIBOR+5% with a LIBOR floor of 0.75%, the loan will never have a coupon of less than 5.75%. However, if LIBOR is at 0.25%, it would take a 50bps increase before the coupon on the bank loans will be adjusted.

Conclusion

Investors still interested in investing in bank loans should do their due diligence on the available options and consider several key features of each investment:

  • liquidity matching – no bank loan fund will have perfect liquidity matching with the underlying securities unless it offers monthly liquidity. Look for as little variance as possible.
  • Active vs. passive management – its quite possible that the importance of active management is no higher than it is in the bank loan space. These are risky securities and passive investing may not necessarily reflect the best possible investments in the space for a given level of risk.
  • Fund size – a larger fund is not necessarily better than a smaller fund. At some point, a fund may be so big, it may not be able to find adequate buyers at reasonable prices when trying to sell positions. Is the PowerShares fund at $7 billion too big. Only a stress scenario will reveal that, so proceed at your own risk.

Bank loans can be a great diversifier to a well balanced portfolio and will certainly complement other types of fixed income investments. But like any other investment, the returns come at the peril of certain risks. Know these risks before investing.

Cohen & Steers: The King Of REITs Poised To Provide Investors 42% Annualized Returns

Cohen & Steers: King of REITs

Retail investors are increasingly looking for ways to further diversify their portfolios to avoid a repeat of 2008-2009, where they saw both equity and fixed income holdings decline concurrently. One asset class that has received plenty of attention and is expected to grow five-fold in 6 years is the Retail Liquid Alternative (RLA) space, where Cohen & Steers (CNS) is well positioned as the pioneer in real estate related securities. With its strategic initiative to expand into other retail liquid alternatives and well developed distribution channels, CNS stock can grow 8x in our base case scenario.

European Equities: Fear Not What Can Help You Achieve Your Financial Goals

If you live in fear of the future because of what happened in the past, you’ll end up losing what you have in the present. Fred Frailey wrote an article on Kiplinger that although is outdated, has a quote that I believe is timeless. In the last paragraph of the article, he states:

Achieving them (financial goals) without the long-term help of the stock market is like driving a car on a flat tire or piloting a 747 on one jet engine. In other words, you may get where you’re going, but you’ll arrive shaken up or in a cold sweat. If you now regard stocks the way my father once did, you had better double or triple the amount you once put aside because you’ll need to buy bales of CDs.

Read more at http://www.kiplinger.com/article/investing/T038-C000-S002-fear-of-investing.html#XqCd1fPAC5uJ38Vl.99

European equities make up part of ‘the stock market’ that Fred is referring to, and while investing only in US equities may be better than not investing in the stock market at all, there are opportunities internationally that should not be ignored.