Most investors have never heard of bank-loan funds. But considering the lethargic bond market, it may be time they listened up.

Except for the headlines about a slugger named Barry, it's been a quiet year for bonds thus far. Due to rising rates, uncertainty over the


rate-hike intentions and strong equity and commodities markets, investors have essentially turned their backs on bond funds.

Five of the 13 bond-fund categories tracked by Morningstar are in the red year to date. Especially lagging the field are intermediate and long-term bond funds, since they are more heavily affected by spikes in interest rates. The average long-term government bond fund, for instance, is down more than 5%, according to Morningstar.

Short-term bond funds, while not losing money, aren't exactly igniting too much excitement, either. For all the talk about investors frantically racing to the front end of the yield curve to protect themselves from higher rates, the space seems far from crowded. The average short-term government and corporate bond funds are barely positive for the year, just squeaking into the green, while the typical ultra-short bond fund is up just 1.4%.

The average bank-loan fund, on the other hand, has returned 2.55% this year. While that's nothing to write home about when precious-metals funds are near 20% and climbing, it's enough to rank such vehicles third on Morningstar's fixed-income list, trailing only high-yield funds at 3.01% and world bond funds at 2.57%. The benchmark 10-year Treasury note sold off dramatically over the same period, sending the yield from 4.4% to 5.06%.

The reason bank-loan funds have not been loitering with the rest of the bond-fund pack is that their yields rise as interest rates rise. And with the fed funds rate continuing to be cranked up from a 46-year low, bank-loan funds are proving to be one of the few defensive alternatives for fixed-income investors.

"The've held up their part of the bargain as interest rates have headed higher," says Scott Berry, research analyst at Morningstar. "No doubt about that."

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, which primarily invests in bonds with fixed rates, the securities held in bank-loan funds have variable rates. 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.

"Rising rates typically erodes bond prices," says Paul Scanlon, head of U.S. high-yield investing at Putnam. "But in this particular case, the prices are sticking around par while yields continue to move up. And that benefits the shareholders."

Bank-loan funds also offer respectable yields at a reasonable cost. The median bank-loan fund yield is 5.7%, with a range of 4.65% to 8.71%, according to Morningstar. The median bank-loan fund expense ratio is 1.3%, compared with 0.7% for the average intermediate-bond fund. While the ratio is higher, it's not a lot, considering bank-loan funds are a truly research-intensive product.

Not Quite Junk

While bank-loan funds sound a lot like high-yield or "junk" bond funds because of the financial difficulties of the companies involved, there is a major difference between the credit quality of bank loans and junk bonds. Bank loans are considered safer than high-yield bonds because these loans are senior in the capital structure. In other words, bank loans get paid before bondholders get paid, and are also collateralized by the issuer.

"The recovery rate on bank loans is 80 cents on the dollar, compared to 30 cents on the dollar for high-yield," says Scanlon. "So not only do things go wrong a smaller percentage of the time, you get more money back if they do."

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 to 2002, many of the funds, particularly those with heavy telecom and technology exposure, posted slightly negative or flat returns. High-yield issuers also tend to delve in the bank-loan fund world, so the two asset classes -- justifiably or not -- often move in tandem.

"Bank-loan funds are a good way to diversify an interest-sensitive bond portfolio, but they are not risk-free," says Morningstar's Berry. "These are still low-quality bonds, and there is still the possibility of default. But on the plus side, the loans are all senior and secured, so they get paid first."

"It's a growing asset class," Berry adds. "We've seen a few entrants in recent years making it more of a mainstream product, but it still has a ways to go."

That is, only if investors start listening.