Bank Loan Funds: Navigating Rising Interest Rates & Economic Recovery

Getty Images

As interest rates fell in 2019 and 2020, investors paid bank loans little attention. But an economic recovery and the likelihood of rising short-term interest rates are prime conditions for these loans, which pay an interest rate that adjusts every few months in step with a short-term bond benchmark. When yields rise, most bond prices fall. But bank loans, often called floating-rate loans, retain their value.

The managers at Fidelity Floating Rate High Income (FFRHX), Eric Mollenhauer and Kevin Nielsen, perform detailed analysis on each company before they add a bank loan to the fund.

Bank loans are typically issued to firms that have junk credit ratings (double-B to triple-C). That means they have a higher risk of default, so Mollenhauer and Nielsen are right to be choosy. Along with 20 analysts, each an industry specialist, the managers build a diversified portfolio one loan at a time based on a company's prospects over the next two to three years.

Floating Rate High Income has a reputation for being more conservative than its peers, tilting toward firms rated double-B, the highest-quality end of high-yield credit ratings. That's still true, but lately the fund holds more of its assets than usual in loans rated single-B.

These days, it's a risk worth taking.

"With an accommodative Federal Reserve, pent-up demand and the potential for a big infrastructure package, our companies are set up well," says Nielsen. The fund currently has decent exposure to hotels and leisure companies. Outdoor gear retailer Bass Pro Shops is the top holding.

Regional firms once dominated the bank-loan market, but since 2008 it has more than doubled in size, to $1.2 trillion – as big as the high-yield bond market, says Mollenhauer. Companies search for such financing because the loans offer flexibility. They are short-term, with an average maturity of less than five years, and the loans can be paid off at the borrower's discretion. Now, many household names fill the market, including Caesars Resorts and Charter Communications (CHTR).

Since Mollenhauer took over in 2013 (Nielsen joined in 2018), the fund's 3.5% annualized return has beaten the typical bank-loan-fund but trailed the benchmark, the S&P/LSTA Leveraged Loan index. The fund yields 3.03%.