Why Avoid Bank Loan Fund Investments

Funds obtained through the acquisition of bank loans and turned into an investment has been gaining popularity among investors lately. They are seeking investments with high returns and safe from fluctuating (increasing) interest rates. A rational investor should avoid funds acquired through bank loans.

A bank loan is a credit provided by banks to their clients. Bank loans are related to the junk bond fund and floating rate note fund. However, there exist some similarities and differences between these three entities. For instance, a floating note fund, just like a bank loan has a varying (floating) interest rate. On the other hand, a bank loan fund differs from a floating note fund. The reason is, it trades on private markets that are illiquid.

From a layman’s assessment, bank loans are good news to anyone wishing to make an investment. When it comes to the capital structure of a company, a bank loan is usually senior. This is in spite of the unwanted credit status that accompanies these loans. Senior loan means that should the company go under or become bankrupt, these loans are the priority, and thus cleared first. In a typical case, these loans are under security which is in most cases the company’s asset. This security allows the bank to seize the asset linked to the loan in question.

From history, it is clear that there is a high rate of default on bank loans, just as is for junk bonds. For instance, the average default rate for a bank loan is 3-4.5 percent. During the 2009 financial crisis, bank loan default rate reached its highest of all times at eleven percent. When making a contrast between bank credit and government bond, you will learn that government bonds are risk-free. For this reason, they make a better investment than bank loans.

Bank loans are associated with one major problem that investors may be ignorant of; the loan market is illiquid. Based on the fact that bank loan processing needs some paperwork, it may take quite some time before it is completed. This could further complicate cases where the investor is a foreigner coming in to invest.

For international banks whose operations are still centralized, investors in funds are not likely to get the value of their investment. This is due to the processing time involved. As a consequence, the market may go into panic mode resulting in the inability for the funds to sell the loan in their portfolio.

When the market is in panic, the funds could lead to large withdrawals which could also result in the inability to sell off the loan. This is a problem for the investors. Due to the illiquidity of these bank loans, the price of the fund can go down than the underlying bank loan’s price.

Do investors get compensated for taking an extra risk in buying illiquid securities that are of low-credit quality? The answer is no.

There is a high risk involved in engaging in a bank loan fund. According to some federal Government offices, there has been a declining standard of underwriting in this market. Also, BlackRock CEO Laurence Fink has described these funds as being too risky for the company to rely on as a source of capital.

In conclusion, funds from Bank loan constitute illiquid investments. This makes them vulnerable whenever there are market panics. We’ve also seen that investing in bank loans is inferior to investing in grade bonds. And of course, due to LIBOR floor clauses, varying interest rates in a bank loan market may not guard the investor from the increasing rates. So, no one can argue that it is irresponsible for anyone to get a bank loan from banks for investment purposes.