The

Federal Reserve

has bond fund holders shaking in their seats over an impending series of interest rate hikes starting this summer. Across the board, bond funds are suffering a particularly frightening month.

But there has been a survivor in this Fed version of a slasher flick: bank loan funds.

Of the 12 taxable bond fund categories listed on Morningstar, the bank loan group is the only one still positive over the past month with a slim return of .01%. And for the year to date, only bank loan funds and ultra-short bond funds, at 1.14% and 0.35%, respectively, remain in the green (see chart).

Bank loan funds' lone basis point in positive territory may seem somewhat puny, but it's actually impressive considering the benchmark 10-year Treasury note sold off dramatically over the same period, sending the yield from 4.23% to 4.76%.

The reason why bank loan funds have not been spooked by Fed Chairman Alan Greenspan's rate hike campfire stories -- however "measured" they may be -- is that their yields rise as interest rates rise. And with the fed funds rate headed up from a 46-year low, bank loan funds are proving to be one of the few defensive alternatives for fixed-income investors.

How They Work

Bank loan funds invest in loans packaged and issued by banks and other financial institutions mostly to distressed companies. Since the loans are geared for struggling companies, there is default or credit risk -- similar to that of junk bonds -- so the interest rates offered are higher than usual.

Unlike the typical bond fund, however, which primarily invests in bonds with fixed rates, the securities held in bank loan funds are variable rate ones, which means they change every few months. Therefore, the rates on the loans held in a bank loan fund will rise along with interest rates. In turn, the yield on the fund rises as well.

"You get the best of both worlds with bank loan funds in the current environment," says Scott Berry, analyst at Morningstar. "You get lower default risk because of the strengthening economy, plus you are earning more yield as interest rates rise."

Bank loan funds also offer respectable yields at a reasonable cost. The average bank loan fund yield is 3.5% with a range of 2.5% to 5.5%, according to Morningstar. The average bank loan fund has an expense ratio of 1.45% compared to 1.1% for the average intermediate bond fund -- not a lot considering this is a truly research-intensive product.

"People are less familiar with the downside of bonds," says Scott Page, portfolio manager for the $2.5 billion

Eaton Vance Floating Rate Fund

(EVBLX) - Get Report

. "And now they are discovering the problem of interest rate risk. In bank loan funds, the interest rate risk is almost zero."

Managing Inherent Risks

Interest rate risk is the amount the price of a bond decreases when rates increase. Page avoids interest rate risk in his fund by pegging his variable rate loans to the London Interbank Offered Rate, also known as LIBOR, which is reset every 60 to 90 days.

Page says he reduces credit risk -- the risk of a company defaulting on a loan -- by diversifying his portfolio among 300-400 loans. He also tries to minimize credit risk by sticking with established, albeit troubled, companies with significant revenue typically in the $600 million range. Page says as a rule he would rather "sacrifice a slightly higher yield in favor of a company that's a better credit risk."

While bank loan funds sound an awful lot like high-yield, or junk bond, funds due to the financial difficulties of the companies involved, there is a major difference between the credit quality of bank loans and junk bonds.

Richard Hsu, portfolio manager of the $457 million

Franklin Floating Rate Daily Access Fund

(FAFRX) - Get Report

, says the general credit quality of bank loans are superior to high-yield bonds because they are senior in the capital structure -- bank loans get paid before bondholders get paid -- and are also collateralized by the company.

Being higher in the capital structure than junk bonds, however, is not the same as having a triple-A rating. So when default rates rose during the economic downturn of 2000-02, many of the funds, particularly those with heavy telecom and technology exposure, posted slightly negative or flat returns.

But Morningstar's Berry says the group bounced back in 2003 with a healthy average return of 10.36%, a level which neither Page nor Hsu believe can be repeated in 2004.

"I don't expect the same level of capital appreciation we saw in 2003," says Hsu. "But I expect a yield of 2.5% to 3.5%, which is still very good."