Where bond investors find a haven from rising rates

Bank-loan funds continue to outpace most taxable bond-fund categories.

By Martin Skala | Correspondent of The Christian Science Monitor

from the July 30, 2007 edition

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How do you preserve capital when the bond market heads south?

It's a perplexing issue for many bond-fund investors, who saw their fixed-income holdings unexpectedly shrink in value during this year's second quarter. As long-term interest rates rose, bond prices fell and most types of bond funds had negative returns of 1 to 2 percent. Many economists expect sluggish economic conditions in the United States to improve in the second half of the year despite the drag of a weak housing sector. That's likely to keep upward pressure on interest rates, even if Federal Reserve policymakers hold the benchmark federal funds rate steady at 5.25 percent, analysts say.

While an upswing in rates is generally bad news for bond funds, one specialized slice of the bond-fund universe, bank-loan funds, has little to fear from an advance in rates. That's because these funds benefit from the floating-rate nature of the assets they hold. So far this year, according to Morningstar, bank-loan funds have returned 2.5 percent, outpacing all but one type of taxable bonds fund (emerging markets). Over the past three years, the average bank-loan fund has returned 5.2 percent annually compared with 3.4 percent for the average taxable-bond fund.

The funds, also called "loan participation" funds, buy pieces of adjustable-rate loans that banks make to corporate borrowers with less than investment-grade credit ratings. The rates are typically reset every two to three months based on an interbank lending benchmark that has been edging up lately.

If interest rates rise, bank-loan funds are a "more prudent choice than most bond funds because of their low volatility," says Scott Page, comanager of the Eaton Vance Floating Rate fund. Bond prices move inversely to interest-rate changes, but the net asset values of bank-loan funds should be more stable than most bond funds, he says.

"The reset feature is what makes the funds attractive in a rising-rate scenario, because it protects your principal," agrees Paul Herbert, an analyst at Morningstar.

Dividend payouts on bank-loan funds range from 6.25 to 8 percent. Those with the highest payouts, he says, typically plow a portion of their assets into dicier junk bonds and use borrowed money as leverage to enhance yields.

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