By Brendan Conway

Moodys Investors Service  today joins the fund executives and analysts who warn of potential trouble in bank-loan mutual funds and ETFs. The firm says those funds suffer from a structural design problem that could result in reputational risks for their creators, such as Eaton Vance, Fidelity Investments and Invesco. if and when the funds dont behave the way investors expect.

Its a twist on the argument made by BlackRocks (BLK ) Larry Fink and again by BlackRocks Matt Tucker over the weekend in Barrons : Theres a mismatch between the ease of owning something as readily tradable as an ETF, and the difficulty of owning loans.

Moodys Stephen Tu  and three coauthors give the key data point: Many bank loans have settlement procedures of 15 to 25 days, and some take even longer. How do fund companies meet investor redemption requests if and when those investors each decide to crowd out the door at once and they expect to get their cash right away?

The answer at Moodys: They may be unable to do so. So, ETF prices could behave erratically. Mutual-fund net-asset value estimates could become less than meaningful. Investors would likely be hopping mad.

The decision to put such loans inside a highly liquid public fund creates a structural mismatch, the firms analysts argue, adding that they consider inadequate the several methods fundmakers have devised to get around this mismatch.

One of those methods is to hold a portion of the portfolio in junk bonds, for the reason that they often behave similarly.

Most of the funds under scrutiny at Moodys were partially invested in junk bonds at the time the firm undertook its research. Several held a few percentage points of their portfolios in cash. The biggest, the $21 billion Oppenheimer Senior Floating Rate A (OOSAX ), had a negative cash position (the fund is able to deploy leverage). Fidelity Floating Rate High Income (FFRHX ) was nearly 6% in cash. Eaton Vance Floating Rate A (EVBLX ) had positions in both cash and junk bonds.  PowerShares Senior Loan Portfolio (BKLN ), the biggest ETF, was more than 9% invested in junk.

While fund executives seem confident they can weather a selloff, the Moodys analysis suggests you dont want to be around in a panic. Heres more from the firms discussion of what its analysts consider less-than-adequate steps to make up for bank loans poor liquidity:

Asset managers generally have three methods to address the asset-liability gap: 1) holding a portion of the fund’s assets in cash, 2) holding a portion of the fund’s assets in bonds, or 3) establishing credit facilities which can be used as a source of liquidity. Each method has drawbacks and collectively they are inadequate to meet large-scale investor redemptions. Holding cash is effective in meeting investor redemptions, but leaves capital un-invested relative to the bank loan index or market. Bonds are securities which settle within the same time period as most ETFs and mutual funds, and as a result can be used to meet investor redemptions. They also help the fund remain invested, however they will cause performance to diverge from the loan market. Collectively, these more liquid instruments typically cannot exceed 20% of most funds per their investment guidelines.

Other means of paying investors include increasing fund leverage and delivering securities in-kind. Credit facilities can be used as sources of liquidity to meet redemptions, but will increase the fund’s leverage and exacerbate a deteriorating liquidity profile if redemptions continue. Ultimately, the Investment Company Act of 1940 limits leverage to 33 1/3%. Some funds reserve the right to meet investor redemptions with delivery of securities from the fund. This option could satisfy redemption requests, but is not a payment of cash to investors. Additionally, this would likely subject investors to the additional costs and risks of liquidating illiquid instruments, and it is unclear how the assignment of private bank loans to retail investors would be feasible.

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