For most bond owners, a rising interest rate environment
is portfolio poison. As rates climb, the price of existing bonds
falls. One possible way to offset that decline is by investing in
bank loan funds, also known as floating rate funds. These funds
can be a risky but rewarding alternative to more traditional fixed-income
Bank loan funds consist of loans made by banks or
other financial institutions to companies and are often below investment
grade. While they're not true fixed income -- you can lose money
-- they can provide a return equal to or better than high-yield
money market accounts. That is because the loans that comprise the
funds are very short-term, giving lenders the opportunity to frequently
raise the interest rate. This ability to keep pace with interest-rate
changes also helps keep your principal more stable than the typical
Many portfolio managers say that the way these loans
are structured removes much of the risk to investors. The loans
are typically secured by cash or assets or other property. There
are no independent ratings, but experts say the bank should have
done its due diligence. The bank packages the loans and sells them;
which is where the funds come in.
||Bank loan funds at a glance
Bank loan funds are senior loans, meaning that, should
the company default, these loans take precedence over other debt
and have to be paid back before bond holders. You may not get enough
to cover your initial investment, but there's less risk than with
a high-yield bond. Typically, investors get back 75 cents to 80
cents on the dollar when there's a default.
Short term, quick turnover rates
These investments should be thought of as short-term, high-yield
bonds with terms -- often 30 days, 60 days or 90 days -- that are
much shorter than typical high-yield bonds.
You have a better chance of not losing principal because
the interest rates on the loans reset very quickly. Short-term interest
rates rise and fall in response to rate hikes by the Federal Reserve.
That, combined with the quick turnover rates of these short-term
loans, means these funds respond quickly to a rising or falling
interest rate environment.
You can buy bank loan funds through many companies
including AIM, Fidelity, Eaton Vance, Merrill Lynch and Oppenheimer.
Be sure to check how much each fund charges for the expense ratio.
They tend to be high in this particular asset class.
Liquidity may be an issue for some investors. Many
funds in this group allow investors to buy shares at any time but
restrict redemptions to monthly or quarterly. Some, such as Fidelity,
Franklin and Eaton Vance, have funds that allow redemptions anytime.