Comparing Corporate Debt Mutual Funds

Characteristics of middle market loans

Commercial loans made by asset managers or nonbank lenders typically have a five- to seven-year maturity and charge floating interest rates based on a reference rate, such as three-month Libor or SOFR, plus an interest rate spread to compensate for the risk of loss from borrower default. The interest spread varies depending upon many factors, including the perceived riskiness of the borrower, industry, loan-to-value (LTV) ratio, seniority, covenants and other factors. In addition to interest income, lenders receive an “original issue discount” (OID) for originating and underwriting the loan. OID is received when the loan is issued in the form of lender proceeds that are 1% to 3% less than the final principal. This upfront price discount is generally considered additional interest income and is amortized over the life of the loan. In addition, middle market loans receive fees for loan prepayments, which can total a one-time 1% to 2%.

Middle market loans are generally not rated, are considered non-investment grade and are not traded in the secondary market. As a result, yields are generally greater than traditional broadly syndicated bank loans and publicly traded high-yield bonds.

The growth in direct middle market loans originated by asset managers is partly explained by the growth in middle market private equity. These loans are referred to as “sponsor-backed.” Private equity sponsors often prefer to borrow from asset managers rather than traditional banks because asset managers offer faster speed and certainty of execution and greater financing flexibility.

Investors in middle market loans can preselect the types of risks they want to take. For example, many investors, particularly first-time investors, choose the least risky senior secured loans, with yields currently averaging about 7.5%. More experienced investors, or those seeking further diversification, may be comfortable investing in second lien or mezzanine loans, with yields currently in the 12% to 15% range. Also, investors may choose middle market loan funds that use some leverage. Portfolio financing is readily available to managers with strong track records and performing loan collateral, and private funds focused on senior secured loans often use one to two turns of leverage to enhance return.

Middle market loan performance is the combined outcome of (1) interest income, (2) realized losses through impairments, (3) unrealized net gains or losses from periodic valuations, and (4) fees and expenses.

Accessing the asset class

One way to access the corporate debt risk premium in a highly diversified way is with Cliffwater’s Corporate Lending Fund (CCLFX). The fund, now with more than $8 billion in assets at the time of writing this article, is highly diversified across about a dozen industries and private lenders, with more than 3,100 individual credits, with an average loan size of only about $3 million, representing a small fraction of the underlying loan size. The vast majority of the fund’s investments are senior secured loans to companies backed by private equity. Cliffwater does use leverage within CCLFX (the regulatory maximum is 0.5 times net assets). However, fees are applied only to net assets, not gross assets; fees are not applied to the levered assets. Assuming 30% leverage (the fund’s long-term target average), the 1.65% expense ratio (ER) becomes 1.27% on investor assets (investors are paying $1.65 per $100 of their assets, but the fund would have $130 of assets, and $1.65 on $130 of assets is 1.27%). Thus, the effective ER is 1.27%, not 1.65%. And importantly, in contrast with many other direct lenders, CCLFX does not charge a performance fee.

In its annual 2022 survey of 49 of the largest middle market direct lenders, managing $541 billion in direct lending assets, Cliffwater found that the average fee was 3.14%. At an effective fee of 1.27%, CCLFX’s ER is less than half the average fee.

A concern, or objection, to the use of this fund is that its “posted” ER is much higher compared to other passive/systematic investment strategies and compared to daily liquid corporate credit funds. Compared to Invesco’s Senior Loan ETF (BKLN) – with about $4 billion in assets under management (AUM) invested in senior secured syndicated bank loans – and Vanguard’s High Yield Corporate Fund (VWEHX) – with about $26 billion in AUM invested in publicly traded corporate bonds – CCLFX’s ER is much higher, at 1.65%, a full percentage point higher than BKLN’s ER of 0.65% and 1.42 percentage points higher than VWEHX’s ER of 0.23%. While the ER is relatively high, the fund doesn’t operate like the typical index fund – it is not buying an index of publicly available securities. One needs to have the proper perspective to evaluate the fee.

Passively managed funds, like index funds, buy and hold publicly traded, liquid investments. And they are systematically managed in a transparent and replicable manner, resulting in low expense ratios, though typically higher than for similar index funds. An investor should be willing to pay a higher fee for funds that can add additional value through providing deeper exposure to factors (such as size, value, probability, and momentum). Systematically managed funds also can add value through intelligent design (screening out securities that similar index funds would hold because they have historically earned lower returns) and patient trading. In other words, one shouldn’t consider only the expense ratio but also the value added relative to the expense ratio. CCLFX is a very different type of fund than either BKLN or VWEHX.

CCLFX doesn’t invest in publicly traded, highly liquid securities. Instead, in effect, CCLFX is running a bank that makes loans to private companies – it reviews and approves every loan submitted to it prior to investing. And it seeks to be very conservative in its lending, noted by the average LTV of only about 30% as of June 2022 (that low LTV allows CCLFX to borrow for leverage at very low costs; its debt is AA-rated). With that in mind, investors should ask: Is this a good alternative to BKLN and VWEHX? To make that determination, we will analyze the yields and expected net returns to investors seeking corporate credit risk exposure, comparing CCLFX to BKLN (which also makes floating rate senior secured loans) and VWEHX, which invests in publicly traded high-yield bonds.

The following analysis will demonstrate why, despite the relatively high ER, CCLFX is a good alternative, which also explains why investors are receiving value for the fee paid. I will begin my analysis with the expected returns to that of BKLN and CCLFX. For educational purposes, the following example is hypothetical but is based on current market yields and historical realization of gains and credit losses.

*SOFR was 1.45% as of June 21, 2022.
**Secondary market gains, seed stakes in newly formed funds where CCLFX gets a GP stake for being a seed investor, and returns from opportunistically buying BDCs trading at significant discounts to net asset value (NAV).
***Loan impairments.
**** The fund earns 6.16% above SOFR and pays 1.91% above SOFR for net return of 4.25% on the levered assets; 4.25% x 30% leverage results in net return to fund of 1.28%.
***** Since the 1.65% fee is applied to investor assets, assuming 30% leverage reduces the effective ER on gross assets to just 1.27%.

For CCLFX, neither the yield above SOFR at 6.17% (7.62% accounting for SOFR yield of 1.45%) nor the expected realized gains include the historical returns earned from origination discounts, which have averaged about 83 basis points if amortized over three years – about the average life expectancy of the loans. Doing so would bring the expected return to 7% before accounting for SOFR, or 8.45% accounting for SOFR.

From the above table, despite having an ER that on the surface is 0.99% higher than that of BKLN, CCLFX has a higher expected return of about 3.4 percentage points without even including the 83 basis points expected from origination discounts. In addition, CCLFX’s conservative lending policies have resulted in significantly lower default losses – higher expected net returns with less economic cycle risk and less inflation risk.

VWEHX

The other alternative, Vanguard’s VWEHX, has an ER of just 0.23%. Using the June 21, 2022, SOFR of 1.45%, we’ll compare the expected return to CCLFX of 7.62% (before considering origination discounts, or 8.45% considering them) with that of VWEHX. The option-adjusted yield on VWEHX as of June 22, 2022, was 4.92%. It also had a duration of about 4 versus just 0.25 for CCLFX. Subtracting the 0.23% ER brings the expected return down to 4.69%. Even without considering expected credit losses, CCLFX has a significantly higher expected return (8.45%) and has about four years less of inflation risk.

Using 20-year default rates by rating from JPMorgan and applying VWEHX rating weights as shown by Morningstar, the estimated weighted-average default rate is 1.25%. Using the same historical information from JPMorgan, a 40% recovery weight (60% loss rate) applied to the 1.25% default rate results in a 0.75% credit loss rate (1.25% x 60%). Subtracting 0.75% (expected losses due to loan impairments) from 4.69% (yield minus the ER) provides an estimated return of 3.94% – just a 2.49 percentage point yield above the current SOFR yield (versus 7% for CCLFX). Once again, one can see that by considering only a fund’s ER, investors can make very poor choices, as CCLFX has significantly higher expected returns, lower duration/inflation risk and also less credit risk. Thus, for investors willing and able to accept limited liquidity, CCLFX should be the preferred investment vehicle. (Vanguard shows a default history for VWEHX of just 0.27%. However, funds like VWEHX can sell bonds that have fallen in rating before default occurs. Thus, they incur losses while not reporting defaults. For example, currently VWEHX holds only about 5% of its assets in bonds rated below B. Using actual historical defaults by rating is a more appropriate methodology for estimating the impact of credit risks.)

The following table shows the year-by-year performance of CCLFX, BKLN and VWEHX from July 2019 through July 2022:

*Returns from Portfolio Visualizer. Time period selected based on the longest data available on Portfolio Visualizer.

The analysis shows that once the expected returns from origination discounts are included, CCLFX has an expected return above SOFR of 7%, or 4.2 percentage points higher than that of the 2.8% for BKLN and 4 percentage points higher than that of the 2.5% for VWEHX. Since inception, CCLFX has outperformed those estimates, providing a 7% higher return than BKLN and a 6.3% higher return than VWEHX.

Summary

There’s a cliché about individuals who know the price of everything and the value of nothing. That applies to investors who focus solely on the expense ratio to judge the worthiness of an investment. The right way to think about the expense ratio is whether the return expected after all costs compensates the investor for the risks taken, and how the addition of that investment impacts the overall risk and return of the portfolio.

Hopefully, the above examples demonstrate that when viewed through the proper lens, investors are receiving good value for their investment in gaining exposure to corporate debt risk through a fund like CCLFX. The “equitylike” expected returns are compensation for the risks of occasional significant losses (due to economic cycle risks) as well as the illiquidity created by the interval structure, which limits the maximum liquidity the fund must provide to 5% per quarter and 20% per year. However, for those investors who don’t need daily liquidity for at least some significant portion of their portfolio (likely true for almost all investors), the illiquidity premium, while not a free lunch, can be viewed as a “free stop at the dessert tray”!

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. The above performance related information is for educational purposes only. The funds mentioned may not be suitable for all investors, based on their willingness, need, and ability to take risk. Investors should carefully consider the Fund’s risks and investment objective, as an investment in the Fund may not be appropriate for all investors and the Fund is not designed to be a complete investment program. There can be no assurance that the Fund will achieve its investment objective, or the estimates/projections provided. An investment in the Fund involves a high degree of risk. It is possible that investing in the Fund may result in a loss of some or all of the amount invested. Interval funds involve additional risk, including lack of liquidity and restrictions on withdrawals. Before investing in the Fund, an investor should read the discussion of the risks of investing in the Fund in the prospectus. Investors should review additional detailed information, including related risk about the Cliffwater Corporate Lending Fund. Your advisor can provide additional detailed information, including a more extensive Investor Guide. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, confirmed the accuracy, or confirmed the adequacy of this article. LSR-22-317

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