Bank loan funds may provide high-yield option
|By Laura Bruce Bankrate.com
The search for higher yields may lead you to bank
loan funds, also known as floating rate funds or senior
The first claim on a company's assets. If a company goes bankrupt,
senior creditors get paid first. funds. While these
bond funds carry impressive yields, they can be complicated and
are not usually thought of as an especially good investment in a
falling-rate environment. Nevertheless, a careful investor may find
some opportunities in the current climate.
Bank loan funds are a bit of an odd duck in the bond world in that they don't have the traditional correlation of rates rising as prices fall and vice versa. The yields tend to rise as interest rates rise. Most of these funds are composed of below-investment-grade corporate loans that pay a high yield.
The difference between these and junk bonds is that
the loans are secured with company assets and they are senior. If
the company defaults, these loans may not be paid off first, but
they'll be ahead of many others. But that doesn't mean they're risk-free.
"In the past, a lot of these funds were sold as money
market alternatives, but they are considerably more risky," says
Scott Berry, Chartered Financial Analyst, or CFA, at Morningstar Inc. "You could lose
some principal. In July alone, the average fund lost 3 percent."
Most bank loan funds are closed-end
Mutual funds whose shares trade like a stock and the price per share is determined by demand, above or below the net asset value, or NAV. A fixed number of shares are available to the public.. These differ from traditional open-end mutual fundsOpen-end funds:
No limit on the number of shares a fund will issue. The net asset value, or NAV, is determined
by the prices of the stocks or bonds held in the fund.
in that a fixed number of shares are offered to the public. The
shares trade throughout the day like a stock, and the price per share
is determined by demand; it can be above or below the net asset
value, or NAV.
Open-end funds can issue an unlimited number of shares. The NAV is determined by the prices of the stocks or bonds in the fund. Open-end funds usually keep a sizable portion of the investment in cash to pay customers when shares are redeemed.
Three investment options
Berry says there are basically three options: the true open-end mutual fund, continuously offered closed-end funds and the true closed-end fund.
The true open-end fund is the newest version of the bank loan
fund, and just like any other mutual fund, you can buy and sell
it every day at NAV. Berry says you'll find these funds for sale
at Eaton Vance, Fidelity and other companies.
Then there are continuously offered closed-end funds.
You can buy them any day at NAV plus any sales charge, but you can
only sell quarterly. And finally, there is the true closed-end fund,
which trades at a premium or a discount to the NAV, but is easy
to get in and out of because it trades like a stock.
For example, Nuveen Floating Rate Income Opportunity Fund (NYSE: JRO) is a closed-end fund that, as of this writing, has a yield of nearly 10 percent. It recently listed its NAV at $13.45 on a day when the closing share price was $12.85. That means the shares were trading at a 4.46 percent discount.
Rapid response to rates
The reason these funds are also called floating rate funds is because the bonds represent short-term loans with terms that reset every 30, 60 or 90 days. When short-term rates are rising, lenders can raise interest rates and the funds respond quickly to the rising interest rate. Additionally the short reset period helps maintain a stable principal value.
Closed-end bank loan funds operate using leverage, which can be a problem in a slowing economy if it means companies are more likely to default on their loans. The open-end mutual funds don't normally use leverage.
William Larkin, portfolio manager at Cabot Money Management
in Salem, Mass., prefers closed-end funds at this time.
no one really knows what's going to happen with the bond market,
so I use these within an asset allocation with a 5 percent weighting," he says. "I like the product, this type of strategy, this type of security,
because it's not very closely correlated with other bonds and it
spills off some nice income.
"When we have very low short-term rates, the closed-end funds
are a perfect place to be because they're borrowing very cheaply,
investing that loan, and enhancing the size of their portfolio,
but they're collecting much higher yields."