The Risk Bug Is Biting Bank Loan Funds

To watch a video presentation on this report from reporter Gregg Greenberg, please click here.

After a healthy 2004, bank loan funds seem to be coming down with the same malady that's punishing the high-yield bond market.

While still up close to 1% since the start of the year, the average bank-loan or floating-rate fund has dropped 0.12% over the past month, according to fund tracker Morningstar.

The dip, however slight, makes it only one of two bond fund categories in the red for the past 30 days -- the other laggard being high-yield funds, which are down 1.39% on average.

What makes bank loan funds' recent stumble surprising is the amount of attention -- and money -- being lavished on the category so far this year. Demand has skyrocketed for bank loan funds, which boast yields that rise along with interest rates, as investors scramble for a steady payout in the face of a low-yield environment and an aggressive Fed. According to Lipper, a Reuters firm that tracks mutual funds, bank loan funds saw inflows of $5.5 billion in 2004, up from $1.9 billion in 2003. In the first quarter of 2005, bank loan funds took in $1.23 billion.

On the supply side, fund families have been trying to accommodate rising demand by adding bank loan funds to their rosters. New funds have recently been offered from the likes of Putnam, MFS and Pioneer.

Fund managers say the froth in the bank loan market may have been a factor in the recent selloff as some investors, chiefly hedge funds, booked profits. But they say the more likely explanation is that problems in the high-yield bond world -- like the recent downgrade of General Motors (GM - Cramer's Take - Stockpickr) and Ford(F - Cramer's Take - Stockpickr) debt to junk status -- are spilling over into their once-staid domain.

"They caught a cold and we got a sniffle," says Scott Page, portfolio manager for the $4.19 billion (EIBLX - Cramer's Take - Stockpickr)Eaton Vance Floating-Rate fund.