Morningstar writes, "The Rise and Fall of Bank-Loan Funds," which tells us, "Bank-loan funds have had a difficult time. The Morningstar Category has endured outflows since late 2018, and following the March 2020 sell-off, it has shrunk to its smallest size since 2012. And the category's narrow return spread--a function of loans' ties to rock-bottom short-term interest rates and limited upside because of call risk--means that fees eat up a larger percentage of returns than in many other categories and make it difficult for individual funds to separate themselves from the pack. Meanwhile, the bank-loan market itself has evolved in a direction that has undercut its traditional role as a credit-sensitive asset with more resilience than high-yield bonds. In fact, the bank-loan sector's traditional downside protection versus high-yield has been eroding for some time. More than ever before, bank-loan investors must ask themselves what they want out of their allocation and whether bank-loan funds are still able to deliver it." The piece continues, "Corporate bonds, both investment-grade and high-yield, typically come with call protections or make-whole features that allow them to trade above par value more easily, increasing their potential total return. But callability means that bank-loan upside is typically capped, while bond upside is not, so improving economic fundamentals--which tend to parallel rising short-term rates--can only go so far in terms of driving up a loan's price. For example, roughly 70% of bank-loan issuance activity in 2017 was used to refinance or reprice existing loans." Morningstar adds, "There is also reason to believe that bank loans' traditional downside protection will not hold as strongly going forward. Huge demand for loans has fostered incredible growth over the years.... Of course, massive growth in both supply and demand paved the way for a loosening of credit standards. As a result, a larger and larger percentage of the market is now made up of covenant lite and loan-only capital structures.... All of this means that bank-loan funds are in a tough place. If outflows continue, the category is likely to experience liquidations or mergers as asset managers shut down uneconomic products. Growth in both supply and demand has engendered changes that have weakened the sector's traditional downside protection. And the lack of call protection will remain an impediment to upside performance whenever credit markets rally, especially in a world of near-zero interest rates that neutralizes one of the sector's defining features and return generators. Given the disadvantages that the category faces, only the very highest level of team and approach--and low fees--can be expected to outperform."

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