Investors who own or are considering buying a fund that invests in leveraged loans should understand the fund’s unique credit and liquidity risks.
What are leveraged loans?
Generally speaking, a “leveraged loan” is a type of loan made to borrowers who already have high levels of debt and/or a low credit rating. Lenders consider leveraged loans to have an above-average risk that the borrower will be unable to pay back the loan (also known as the risk of default). These loans generally pay higher interest rates to lenders because of the higher level of risk.
How do funds invest in leveraged loans?
Investment funds (such as mutual funds and exchange-traded funds) may hold leveraged loans in their portfolios depending on their investment strategy. Some funds may make a small investment in leveraged loans as part of a diverse portfolio, while other funds may invest heavily in these loans. Fund portfolio managers may be interested in purchasing these loans because their higher interest rates could mean a higher return for investors in the fund. Leveraged loans also typically pay a variable interest rate. This means that if market interest rates go up, the interest rate on the loan will also increase. This could help protect the fund from losses if interest rates rise.
How would I know if my fund invests in leveraged loans?
Funds describe how they invest in the strategy section of their prospectuses, and often describe their investments on their website, in fact sheets and in shareholder reports. Funds that invest in leveraged loans sometimes include terms like “high income,” “floating rate,” and “senior loan” in their names.
What are some risks of investing in funds that invest in leveraged loans?
Like every investment, leveraged loans involve a trade-off between rewards and risks. They could cause the fund (and you) to lose money. Risks include:
- Credit default: Borrowers of leveraged loans may go out of business or become unable to pay their debts. This risk could be heightened if interest rates rise or the economy declines. While leveraged loans may be secured by collateral, the value of that collateral may not be sufficient to repay the lender if the borrower is unable to pay back the loan.
- Liquidity: Leveraged loans may not be as easily purchased or sold as publicly-traded securities. In addition, leveraged loans typically have a long settlement period, meaning it could take the fund a long time to get its money after selling its investment. This could present a challenge for a fund if it concentrates its investments in leveraged loans and needs to sell many investments quickly, which could in turn affect the value of your investment.
- Fewer protections: Sometimes leveraged loans are “covenant-lite,” meaning they generally have fewer restrictions that protect the lender than traditional loans. This could leave a fund exposed to greater losses if the borrower is unable to pay back the loan.
- LIBOR: Many leveraged loans pay interest tied to a reference rate known as LIBOR. LIBOR is expected to be discontinued after 2021. For loans that will continue past 2021, it is unclear what interest rates may be paid. This uncertainty may impact the value and liquidity of these loans.
Before You Invest
You should carefully read all of the fund’s available information, including its prospectus and most recent shareholder report before purchasing fund shares.
Asking the following questions might also help:
- What specific risks and benefits are associated with this fund?
- How much does the fund invest in leveraged loans?
- How does the fund’s investment strategy fit with my investment goals?
- How do the fund’s fees compare to other similar funds?