In investors' epic search for yield, one strategy in particular has risen to the top this year—loan participation mutual funds and ETFs. With net inflows to both products reaching over $23 billion this year (through May 8), they are the most popular draw in the fixed-income market. They've even outpaced emerging market equity funds and ETFs as the top attraction overall for the year. Although the strategies have been around for a long time, a combination of factors—including investor concerns about credit risk, interest-rate risk and general volatility—have made them the belles of the ball in 2013.

Loan funds—also known as senior loan, bank loan, syndicated loan, leveraged loan or floating-rate loan funds—are built on the concepts of seniority and collateral claims in a company's capital structure. In the event a company goes into bankruptcy, loan holders typically have the first claim on the assets, followed by bond holders, convertible security owners and preferred shareholders. Common stock owners (who often get short shrift) rank at the bottom of the list. This order of claims preference is important in the loan market; companies that issue loans are generally not investment grade, otherwise they would issue commercial paper (a common ingredient in money market fund portfolios).

Because these companies aren't investment grade, they may also issue junk bonds. However, they can get cheaper short-term financing through a floating-rate loan than they can with a bond. Floating-rate loans (the only type of loan that goes into loan participation funds) are frequently issued to fund buyouts (hence the common "leveraged loan" name) and also to fund general operating expenses, capital expenditures and especially refinancing.

The floating-rate feature is also critically important to loan investors. Unlike bonds, which have a fixed interest rate and whose face value may rise and fall depending on prevailing interest rates, loans are structured to pay a set spread (often something between 200 basis points and 700 basis points, depending on credit quality, industry sector and market sentiment) over a common interest rate, such as LIBOR. In other words, as LIBOR increases or decreases, each quarter the interest rate on the loan resets to match the spread, thus mitigating the interest-rate risk a bond would normally carry.

Given the low-rate environment of the past several years, a concern that "rates have to go up sometime" has prompted investors to seek out products with a reset feature to try to avoid the crushing blow a sudden spike in rates would have on their bonds and bond funds. But, even if rates fall, most loans issued in the past few years contain a feature known as a floor. That floor maintains a minimum interest rate, such as 1.25%, that keeps investor fears of too-low rates at bay and provides attractive current income.

Two Problems
With the duration of a short-term Treasury bill and the income of a junk bond, it would seem a loan fund investor could hardly go wrong. And most of the time, that has been true. But there are two events that can upset the applecart—a major shift in the secondary loan market, as happened in 2008, and a systemic degradation of the underlying loans in the funds.

The events of 2008 highlighted the fact that frequently, the value of a loan fund is influenced by factors far beyond the quality of the loans in the portfolio. Traditionally in these funds, after a loan is made by an underwriting bank, a syndicate of banks divides the loan. Loans syndicated at this time included several types of funding facilities, such as a revolving line of credit, term loans (also called balloon or bullet loans, since the principal comes due at once), as well as amortizing loans similar to a home mortgage.

The collateralized loan obligation (CLO) market, which worked well to finance home mortgages a generation earlier, was repurposed to fund these businesses, and it found an array of buyers of differing risk tolerances—the classic tranche structure. CLOs, like their fellow travelers in the loan market—hedge funds—were also leveraged, and the credit contraction following the collapse of Lehman Brothers hit them particularly hard. Their forced selling into an already hesitant, liquidity-starved market sent prices on loans plummeting, and the normally "par market" for loans sank to 65 cents on the dollar.

Lipper's Loan Participation Funds classification lost 21.6% in the fourth quarter of 2008-far worse than any bond fund group and about as bad as the S&P 500 index (down 21.9%). Although it's unlikely there is another Lehman collapse on the horizon right now, it's important for loan participation fund investors to understand that there are larger players at work in the markets that can dramatically and negatively impact the value of their investment.

Loan fund investors should also be wary of recessionary environments when the quality of the underlying loans can be impacted. Despite low durations and high recovery rates compared to corporate bonds, the health of the loan market is still subject to various business cycles. For example, in the summer and fall of 2002, loan funds lost over 3% of their value when several well-known Internet companies finally kicked the bucket, and the accounting scandal that brought down Arthur Andersen and WorldCom shook the high-yield market.

For investors unaccustomed to seeing a loss in this strategy, it was a bit of a shock. However, that shock didn't compare to what happened starting in November of 2007 when investors lost over 7% in a four-month period (the beginning of the 2007-2009 bear market). For a fund strategy that had not incurred a single month with a negative average return from 1990 to March 2001 (it met the 1990 oil price shock head-on and didn't blink), losing money came as a huge surprise to investors.

Today's investors in loan products, whether in open-end or closed-end funds or in ETFs, will find a market radically different from the one that engineered the smooth, consistent returns of many years ago. Most importantly, the product's surging popularity is sowing the seeds of its own disappointment; more investors mean lighter yields for issuing companies, top-yielding portfolios are diluted by new money and refinancing cuts the value of loans purchased at a premium to their par values.

But for investors starved for income or fearful of rising interest rates (or both), the siren's call of loans will be hard to ignore, and strong inflows are likely to persist. Advisors should be mindful of three warning signs—news that points to increasing default rates on loans, loan prices consistently being over par (100; 98 to 99 cents is typical this year) and LIBOR floors sinking too low (they have fallen from 1.3% to 1.1% in the past year). If these cautionary markers begin to appear, the incremental risk in a market driven almost entirely by below-investment-grade companies may be too much for investors to bear.

Jeff Tjornehoj is head of Lipper Americas Research, focusing
on the United States and Canada. He is a regular contributor
to Lipper's
Fund Flows and Closed-End Reports.