Bank Loan Funds a Hedge Amid Rising Interest Rates

With short-term interest rates on the rise, fixed-income investors are scratching for alternatives to bonds and bond mutual funds, which generally lose money when interest rates climb. One alternative, suggest some financial planners, is bank loan mutual funds.

Bank loan mutual funds—also called floating-rate, senior-secured, or prime rate funds—buy floating-rate loans made by banks to companies with poor credit ratings (junk). The banks typically issue these short-term loans at rates above the LIBOR, the London Interbank Offered Rate, which acts like an international prime rate.

What makes these commercial loans unusual is that, like adjustable rate mortgages for homeowners, they adjust periodically (every 60 to 90 days is the most common) as the LIBOR rate changes. Thus, during a rising interest-rate environment, the yield climbs, putting more money in the investor’s pocket. At the same time, the underlying price of the mutual fund holding these loans usually remains stable, unlike the price for regular bonds or bond mutual funds, which normally falls when rates rise.

Of course, the reverse happens when interest rates decline, as they did dramatically the last four years. Yields on the bank loans decline, but the price usually remains fairly stable. Thus, investors can’t take advantage of the price appreciation that occurs with regular bonds when yields decline. It’s a kind of double hit.

Adjustable rate bank loans are pledged against specific collateral. In addition, in the event of bankruptcy the “senior secured” loan has priority over the company’s stock and bond holders.

How well have bank loan funds performed in recent years? Proponents of the funds point to 1994, when the Federal Reserve raised rates six times. Bank loan funds returned 6.6 percent, versus average losses of 3 percent or more among regular bond funds.

During 2001 and 2002, when bonds and bond mutual funds were performing well, bank loan funds barely broke even. During 2003, as rates bottomed out, total returns for bank loan funds averaged over ten percent. Through June of this year, just as the Fed began raising short-term interest rates, bank loan funds were up nearly two percent, ahead of all other bond categories, according to Morningstar.

Another benefit of these floating-rate funds is that they can provide diversification in an investor’s portfolio because they are not strongly correlated with most types of fixed-income investments including U.S. Treasuries, investment-grade corporate bonds, money markets, international bonds, and municipal bonds. They are, however, more closely correlated with junk bonds.

As with any type of investment, of course, these funds come with risks. The biggest is credit risk because they invest in less financially secure companies, though because of their priority as senior debt, they carry less credit risk than junk bonds issued by comparable companies. Defaults particularly hurt bank loan funds in 2001 and 2002, but many experts believe default will be less of a risk as the economy improves. But if the economy were to enter another recession or a double-dip economy as we witnessed in the early 1980s, floating rate funds could loose money.

Poor liquidity is another investor risk. Most bank-loan funds allow redemptions only monthly or quarterly. Hence, this investment is not a substitute for money market funds. A few of the newer bank loan mutual funds allow daily redemption, but that requires them to hold more in cash and thus lower return.

Floating-rate loan funds are also expensive compared with many bond mutual funds. Expense ratios can easily run over one percent. Although a few of these funds are no-load, consider buying them through a financial advisor who has experience with them and can assess your suitability for them.

Read the fine print of the prospectus carefully. Some so-called bank-loan mutual funds also can invest in other types of assets such as junk debt, preferred stock, low-grade convertible bonds, and various types of derivatives. It’s always important to know the fund, the fund’s manager, and its operating philosophy. Some funds are managed more conservatively than others.

Also be aware that many of the bank loan funds operate as closed-end funds and, depending in part on whether a fund is in or out of favor with investors, trade on a stock exchange at a higher or lower price than the fund’s current net asset value.

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