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Getting Fatter Yields with Bank Loan Funds

NEW YORK ( TheStreet) -- Chairman Ben Bernanke boosted the outlook for most stock and bond mutual funds yesterday when he announced that the Federal Reserve would keep interest rates low until 2015. But investors in bank loan funds had less reason to cheer Bernanke's news. The loan funds rank as one of the few fixed-income assets that thrive during periods of rising rates. When rates sink, the funds can appear less attractive.

Should you stay away from the loan funds? Not necessarily. According to Morningstar, the average loan fund yields 4.2%. That's an intriguing payout at a time when 10-year Treasuries yield 1.78%. In addition, a small position in loan funds can serve as an insurance policy, protecting portfolios against the risk of a sudden spurt in rates.

If rates remain low and the economy continues sputtering along, investors in the funds could obtain decent annual returns of 4% to 5% in the next several years. The risk is that the economy could slip back into a recession. If that happens, investors could worry about loan defaults, and the funds could sink into the red. Lately the risk of defaults has seemed low. Only about 1% of loans have been defaulting annually, well below the average historical rate of 3.6%.

The loan funds invest in adjustable rate debt. When rates rise, the yields on the loans also climb. That is why the funds are resilient in periods of climbing rates. In contrast, conventional bonds pay fixed rates. When rates rise, the values of most fixed-income investments tend to fall.

The bank loan funds invest in debt from companies with below-investment grade credit. Because of the shaky credit, bank loans yield more than investment-grade corporate bonds, which currently yield around 3%.

Bank loans yield less than high-yield bonds, which are also rated below investment grade and yield around 7%. The loans have skimpier payouts because they are considered safer. In the event of a bankruptcy, the loans must be paid first with the borrowers' assets. Investors in high-yield bonds must stand at the back of the line to see whether they recover anything.

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