Floating Rate Bank Loan Funds Hit Rough Patch
April 28, 2003
Floating rate bank loan mutual funds were the low volatility, high-yield, fixed-income fund choice of investors in the mid to late '90s. But since the turn of the century, many of these funds have been searching for a life preserver.
Nuveen Investments of Chicago intends to pull the plug on its $62.6 million floating rate, continuously offered interval fund that launched in October of 1999. The fund will liquidate its assets and close as of May 28, according to a filing with the Securities and Exchange Commission.
The official cause of death is lack of interest. Despite competitive performance returns, the fund "has not been able to generate sufficient sales to reach a self-sustaining level of assets," Nuveen's filing says.
The firm's other prime rate bank loan fund, the Nuveen Senior Income Fund, which is a traditional closed-end fund that trades on the New York Stock Exchange, has a considerably larger $216 million in its coffers and will not be affected.
Nuveen, through a company spokesperson, declined to comment for this article beyond what has already been made public in its filing.
In an unrelated move, Van Kampen Investments, also of Chicago, is asking shareholders of its $265 million closed-end Van Kampen Senior Floating Rate Fund to agree to merge the fund into its nine year older, closed-end sibling fund, the $2 billion Van Kampen Prime Rate Income Trust. Both funds are run by the same manager and in a similar style. The merger will allow for economies of scale as the smaller fund carries a higher expense ratio, according to the funds' recent SEC filing. If approved, the surviving fund will be renamed the Van Kampen Senior Loan Fund.
This past December, PIMCO Fund Advisors announced it would sell The Emerging Markets Floating Rate Fund, which it had been co-managing with Salomon Brothers since late 1997, to the Citigroup subsidiary in a six-fund sale valued at $12.5 million. Last week the closed-end fund officially became the Salomon Brothers Emerging Markets Floating Rate Fund.
Floating rate funds, which are also known as bank loan funds, prime rate funds or senior secured bank loan funds, are fixed-income funds that invest in various loans that banks, bank syndicates and other financial institutions make to corporations. Companies use these loan dollars to finance acquisitions, leveraged buyouts and restructurings.
These loans are dubbed "secured" because companies pledge collateral such as buildings, real estate or inventories against the loans, and "senior" because they have repayment priority over other classes of loans or a company's stock in case a company defaults. Rates of return on these loans "float" and are periodically adjusted to correspond to either the current prime rate or London InterBank Offered Rate (LIBOR).
Bank loan participation funds became a new asset class in 1988, but only a dozen mutual fund advisors jumped into the arena, beginning with the closed-end variety. Van Kampen and Merrill Lynch were among the first closed-end advisors that came out with a spate of offerings. Fidelity pioneered the very first open-end prime rate bank loan fund in August of 2000 as the corporate loan market expanded and became more liquid. Only Eaton Vance and Franklin Templeton were brave enough to follow suit and dive into the open-end universe.
The bank loan fund universe is small, and closed-end funds have been hit the hardest. After suffering $13.5 billion in outflows since the beginning of 2001, only $14.2 billion remain in closed-end bank loan funds as of the end of February, according to Lipper. Open-end bank loan funds took in $1.5 billion during the period and have a total $2 billion today.
Bad Loan Market
Last year proved to be downright ugly for bank loan funds. Weak economic conditions and rampant corporate fraud wreaked havoc on corporations and forced banks to get even stingier with loans, said Derek McGirt, director of Fitch Ratings of New York. Amid the tougher credit market, merger and acquisition activity, which typically drives the need for such loans, was markedly lower, causing a dearth of new loans, he added.
According to Loan Pricing Corp. of New York, overall issuance slipped 12% last year to $969 billion, at the same time that corporate default rates hit record levels.
Last year closed-end bank loan funds eked out an average return of 0.48% after returning a mere 0.13% in 2001. Open-end funds fared significantly better in both time periods, returning an average of 1.31% and 3.93% in 2002 and 2001, respectively.
So far, 2003 is shaping up as a better year, McGirt said. Low interest rates are fueling companies to consider tapping bank loans to refinance old debt, and corporate default rates have plunged by 75% in the first quarter of 2003 versus the first quarter of 2002, according to data from Fitch.
But bank loan funds aren't out of the woods yet. In 2001, bank loan funds' loan valuation methodologies were called into question. Three bank loan fund sponsors, Eaton Vance, Morgan Stanley and Van Kampen, were sued along with their portfolio managers and board trustees. The lawsuits charged that the funds continued to value many of their loans at par value despite the availability of fair market value prices. That improper pricing caused each fund's net asset value to be artificially inflated, plaintiffs claimed. Once fund sponsors phased in the proper mark-to-market pricing, fund share prices took a dive and investors lost millions of dollars, the suits claim. These lawsuits are still pending.
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