As interest rates climb, most bond owners are shaking their heads. The price of existing bonds falls when rates are on the rise. There is a way to offset the decline. You can invest in bank loan funds, also known as floating rate funds. There is a risk to these funds, but they can be a rewarding alternative to traditional fixed-income investments.
Bank loan funds are made up of loans made by banks or other financial institutions to companies. They are often below investment grade. They aren't really fixed income; there is the potential of losing money. The funds can provide a return equal to or better than high-yield money market accounts. The loans that make up the funds are short-term. This allows the lenders the opportunity to frequently raise the interest rate. This helps the funds keep pace with interest rate changes and helps keep the principal more stable than with a typical bond fund.
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According to many portfolio managers, the way the loans are structured removes a lot of the risk to investors. The loans are secured by cash or assets. The funds are not independently rated, but experts say the bank should be able to show you the performance of the fund. The bank will package the loans and sell them, and the funds come into play.
Ban loan funds are senior loans. If the company defaults, senior loans must be paid back before bond holders are. You may not receive enough to cover your initial investment, but something is better than the nothing you could receive with a high-yield bond. Typically, in the case of default, the investors will recover 75 to 80 cents on the dollar.
The change of losing principal is reduced because the interest rates on the loans reset very quickly. Short-term interest rates rise and fall in response to the Federal Reserve. That, combined with the short terms of the loans, makes for a fund that responds quickly to the rise and fall of interest rates.
Many brokerages, including Merrill Lynch and Eaton Vance, sell bank loan funds. In certain asset classes there may be a high expense ration. Make sure that you check every fund out carefully.
Many funds in this group allow investors to buy shares at any time. There are some funds that will allow you redemptions at any time, while others will restrict you to monthly or quarterly redemptions.
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