Where bond investors find a haven from rising rates

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

from the July 30, 2007 edition

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Another positive attribute is that bank loans are secured by collateral and classified as "senior" debt. That gives lenders first call on a borrower's assets in case of default. By contrast, high-yielding junk bonds are generally unsecured or subordinated debt.

As an asset class, the funds show low correlation with bond or stock price movements. That makes them an "effective diversification tool" for fixed-income investors who own different kinds of securities, says Chris Neubert, president of Moneco, an asset-management firm in Southport, Conn. "They can offset some of the interest-rate risk in a bond-heavy portfolio."

The funds have a good track record with respect to controlling volatility, Mr. Herbert adds, but they are not as safe as money-market funds or CDs.

Nor are bank-loan funds true alternatives to CDs or money-market funds, advisers say. If the credit environment were to deteriorate and loan defaults climb, bank-fund values would also decline sharply as they did during the last recession, notes William Larkin, fixed-income manager at Cabot Money Management in Salem, Mass.

Moreover, interest-rate spreads between Treasury bond yields and lower-rated debt, which have been very tight until recently may well widen. "If subprime mortgage debt problems spill over into the bank-loan market, where loans trade in a secondary market, there may be liquidity problems," Mr. Larkin says.

Before selecting a bank-loan fund, investors need to do their homework. Check out fund prospectuses and the most recent shareholder reports. Riskier bank-loan funds use leverage to spice payouts, and that adds to volatility. Funds with payouts above 7 percent deserve close scrutiny, says Herbert. "At this stage of the credit cycle, you want to be more cautious," he says.

Two of Morningstar's favorites are Fidelity Floating Rate High Income Fund, one of the few no-load funds in the group, and Eaton Vance Floating Rate Fund. Both focus on higher-quality loans, possess seasoned credit-research teams, and boast modest expense ratios.

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