Bank loan funds

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 investments.

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 bond fund.

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

• Often below investment grade but return equal to or better than high-yield money market accounts • Very short term • Less risk to investors • Senior loan status typically returning 75 cents to 80 cents on default • Shares may be purchased at any time, but redemptions often are restricted to monthly or quarterly

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.