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By Timothy Strauts

Earlier this week, I wrote an article titled "Should You Consider Floating-Rate Bank Loans Today?" in which I outlined the reasons investors might consider--and why many are flocking to--bank-loan funds in the current environment. Today, I'm going to highlight some of our favorite funds in the sector.

Selecting a Vehicle
There are a number of mutual funds, closed-end funds, and exchange-traded funds that invest in bank loans. There are pros and cons to investing in each fund format that are important to be aware of.

Closed-end funds offer the advantage of having a fixed asset base. Having a committed pool of capital means the portfolio manager doesn't have to worry about being forced to buy or sell securities to manage the flow of money into and out of the fund. This attribute can be particularly advantageous in less liquid sectors like bank loans, which can be prone to panic selling by investors. The drawback of having a fixed asset base is that CEFs can and do trade at regular and sometimes persistent premiums or discounts to their net asset values. CEFs may also make use of leverage in an effort to enhance returns. Of course, leverage cuts both ways and typically will increase volatility.

Exchange-traded funds are a relatively new vehicle for gaining exposure to bank loans. The oldest fund in the category, PowerShares Senior Loan Portfolio (BKLN), was launched just two years ago. ETFs have the advantage of offering below-average fees and intraday liquidity and tend to trade near net asset value. ETF investors have the choice between passive or active strategies in the ETF wrapper. And for investors who value intraday liquidity, the current crop of bank-loan ETFs has greater trading volumes, on average, than its CEF peer group

Relative to CEFs and ETFs, mutual funds have the advantage of transacting at net asset value. Investors who make regular contributions to their portfolio can often avoid paying commissions by investing in mutual funds through a platform with no transaction fees. Most bank-loan mutual funds do not employ leverage.

A comparison of mutual fund and CEF bank-loan category returns sheds some light on the effect of CEFs' use of leverage. As seen in the table below, the CEFs in the bank-loan category had higher average returns over trailing three-, five-, and 10-year periods. However, these returns came at the cost of far greater volatility. The volatility of returns for CEFs in the bank-loan category was 50%-75% higher than the average mutual fund in the category. Morningstar's risk-adjusted return measure provides a better basis of comparison between the two vehicles. This calculation removes the effect of leverage, therefore allowing direct comparisons between leveraged and nonleveraged funds. CEFs in the bank-loan category underperformed their mutual fund peers over the trailing five- and 10-year periods, on average.

(click to enlarge)

Playing Favorites
Nuveen Floating Rate Income (JFR) is a CEF with a Morningstar Analyst Rating of Bronze. JFR has outperformed its CEF category average over the trailing one-, three-, and five-year periods on an annualized basis. The fund invests more than 80% of its assets in bank loans, with the remainder of its portfolio allocated to high-yield bonds, asset-backed securities, and common stock. JFR has a current total leverage ratio of 30% and a distribution rate (based on its share price) of 6.6%. It currently trades at a premium of about 1% versus its net asset value. This is about 2.6 percentage points below its trailing six-month average premium.

Bronze-rated Eaton Vance Floating-Rate Income (EFT) is another CEF option. The fund's portfolio managers currently manage five CEFs and three mutual funds that invest in bank loans. The team follows a conservative strategy that tends to avoid CCC rated loans. The fund's managers believe that the risk of default is too great for these loans, and that investors aren't fully compensated for assuming this risk. EFT has outperformed the category average over the trailing five-year period and has slightly unperformed it over the trailing one- and three-year periods. The fund's conservative approach hasn't been rewarded in the recent bull market, but it should pay dividends over time. EFT has a distribution rate of 5.9% (based on its share price) and has a current total leverage ratio of 36%.

PowerShares Senior Loan Portfolio BKLN was the first ETF to offer exposure to bank loans. As the first bank-loan ETF to market, BKLN has amassed $4.8 billion in assets in its first two years of existence. BKLN has done an excellent job tracking its index. The fund's estimated holding cost of 0.66% is only slightly higher than its 0.65% expense ratio. BKLN tracks the S&P/LSTA Leveraged Loan 100, which is an index composed of the 100 largest bank loans. The ETF has an SEC yield of 4.2% and does not employ leverage.

SPDR Blackstone/GSO Senior Loan (SRLN) is an actively managed ETF that has grown to more than $400 million in assets in the less than four months since its launch. Investors' apparent enthusiasm for the fund is likely attributable to name recognition. Blackstone is an institutional asset manager that specializes in private equity. GSO is a subsidiary of Blackstone that focuses on credit-oriented alternative investments. GSO's experience in bank loans is mainly in the realm of collateralized loan obligations. The type of CLOs that GSO deals in tend to be 10-year investment vehicles that leverage a portfolio of bank loans to produce equitylike returns. GSO currently manages about $23 billion in CLO assets. SRLN is the first daily redemption product that GSO has managed. SRLN's 0.90% expense ratio is low relative to actively managed bank-loan funds. The fund has a current SEC yield of 2.7% and it does not use leverage in the portfolio.

Eaton Vance Floating Rate (EABLX) is the only mutual fund in the bank-loan category with a Morningstar Analyst Rating of Gold. It is one of the largest bank-loan funds with more than $12 billion in assets. Scott Page, who is head of the Bank Loan Investment Group at Eaton Vance, runs this fund as well as the aforementioned Bronze-rated CEF, Eaton Vance Floating-Rate Income. This mutual fund follows a similarly conservative investment strategy without the added risk of leverage. It has a current SEC yield of 3.8%.

Bronze-rated Oppenheimer Senior Floating Rate (OOSYX) is currently the largest bank-loan fund in the market with $12.8 billion in assets. Its veteran managers tend to take on more credit risk than their peers. In 2010, the fund's allocation to CCC rated bonds was 15%--much higher than the average bank-loan fund. Today, its CCC allocation is only 6%. The fund has outperformed the category average over the trailing one-, three-, five-, and 10-year periods, and it has outperformed the category in nine out of the last 10 years. The fund's current SEC yield is 4.9%, it does not use leverage, and has a below-average expense ratio of 0.78%.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Trotting Out Our Favorite Bank-Loan Funds