Highland Fund's secret to success: Avoid bad loans

Mark Okada, who manages two U.S. mutual funds that invest in bank loans to struggling companies, is beating his competitors by dodging bankruptcies.

Okada's $1.4 billion Highland Floating Rate Advantage Fund returned 11 percent in the past year, through May 31, the most among 19 similar funds tracked by Bloomberg, by avoiding borrowers such as Atkins Nutritionals, which defaulted in February 2005.

"Your job as a manager is to create value for your investors by avoiding things before they go down," said Okada, 44, who co-founded Highland Capital Management in 1990.

Okada focuses on the $1.2 trillion leveraged-loan market for companies at risk of failing to pay their debts on time.

Top holdings in April included loans to Georgia-Pacific, Blockbuster and Charter Communications.

Leveraged loans last year unseated junk bonds as the most popular way for companies with credit ratings below investment grade to borrow. Dallas-based Highland Capital is among the biggest investors in the market, with $25 billion of assets, including $19 billion in loans.

Investors prefer loans to bonds because loan prices are more stable, Okada said. Unlike the typical junk bond, loans are backed by a company's assets, making repayment a safer bet in case of a bankruptcy.

Loans also offer protection against rising interest rates because their yields are tied to Libor, or the London interbank offered rate.

The average loan fund rose 4.6 percent last year, beating the 2.5 percent return of the average junk-bond fund in a period when the Federal Reserve increased its benchmark overnight lending rate eight times, to 4.25 percent, according to data compiled by Morningstar.

Highland Capital employs about 75 money managers and analysts to monitor 1,200 borrowers.

Unlike stocks and bonds, loans purchased at face value have limited potential to rise in price as a company's prospects improve because the company can refinance at a lower interest rate.

Highland Capital boosted returns in the past year by buying bank debt of companies in troubled industries such as airlines and automobiles, Okada said.

Such debt can be backed by relatively liquid assets such as spare parts or air routes, and he said companies pay a relatively high interest rate because most investors are reluctant to lend to them.