Bank Loan Funds: Investing Beyond T-Bills

Some risk-averse investors may want a majority of their wealth in non-equity holdings such as Treasury bills, certificates of deposit, and corporate bonds. But returns from these can be anemic. An alternative is an asset class known as bank loans or senior loans.

Bank loans are a multi-class hybrid asset. They are the short-term equivalent of high-yield bonds but with important differences such as shorter maturities, much lower default rates, and variable interest-rate features. Investors generally get
into this asset through a growing number of bank loan funds. The funds have never lost money in any given year, while averaging 2 percent more than T-bills.

Using standard Markowitz portfolio theory, this article studies the return/risk impact of allocating bank loan funds into a predominately bond portfolio. The study assumes an investor initially invested 100 percent in T-bills, with bank loan funds and other assets added to the mix for return requirements ranging from 5 to 10 percent (for years 1990–2005). As return requirements rise, bank loan allocations rise, and standard deviations fall, until allocations begin falling significantly above 8 percent return requirements, giving way to equities.

Bank loan funds should be the first asset class to consider when desiring to increase returns above standard T-bill rates. Otherwise, higher allocations must be given to high-yield bonds in order to attain relevant return levels. A study of future returns reconfirms the ability of bank loans to deliver returns more than commensurate with their risk.

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