Because corporations hold plenty cash on their balance sheets, defaults should remain subdued, says Timothy Strauts, a Morningstar analyst. "This year we should see minimal losses from defaults," he says.
If the economy slips into recession, defaults will climb. But Strauts says that bank-loan funds can deliver positive returns in typical recessions. Since Morningstar began tracking bank-loan funds in 1989, the category recorded losses in only one year -- 2008.
Strauts says the loans suffered in the financial crisis because borrowers were heavily leveraged. These days, borrowers are on much sounder footing. "There is much less leverage in the system now," he says.
For investors seeking a solid mutual fund, a top choice is
Eaton Vance Floating Rate
, which yields 4.0%. The fund tends to shy away from securities that are rated triple-C, near the bottom of the quality spectrum. Instead, Eaton Vance keeps most of its assets in loans rated double-B and B, the top two grades in the below-investment grade market. "The CCC segment is much more volatile and has default risk," says Christopher Remington, an institutional portfolio manager for Eaton Vance.
To boost returns, some mutual funds hold big positions in triple-C-rated loans, which currently yield more than 12%. In contrast, double-B-rated loans yield 3.5%, and B issues yield 4.5%. The lack of triple-C-rated loans hurt Eaton Vance this year, because low-quality issues delivered the best performance. But the low-quality issues can suffer in downturns. Because of its quality focus, Eaton Vance tends to excel in downturns.
At the time of publication, Luxenberg had no positions in securities mentioned.
This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.