NEW YORK (TheStreet) -- If interest rates climb later this year, as economists expect, bond mutual funds will sink.
When rates rise, prices of existing bonds drop, as investors flee older issues in favor of new bonds with higher yields. To avoid trouble, some investors are taking shelter in money market funds. Those hold their value when rates rise. But money markets currently pay microscopic yields, typically ranging below 0.04%.
To juice up your fixed-income portfolio, consider adding a bank loan fund. The loan funds are resilient during periods of rising rates, and they currently yield 4.7%, on average, according to Morningstar.
The funds own bank loans that have been made to companies rated below-investment grade. Because the loans are adjustable, their yields rise along with a benchmark, usually the London Interbank Offered Rate, or LIBOR. The adjustable feature enables the loans to hold their value during periods of rising rates.
LIBOR tends to rise along with the federal funds rate, the short-term benchmark controlled by the Federal Reserve that is currently near zero. Say the fed funds rate rises 1 percentage point this year. LIBOR would likely climb that much too. The yield on a 5% adjustable bank loan would rise to 6%. Owners of bank loan funds would collect the rising income -- and suffer no principal losses. In contrast, owners of short-term bond funds could lose around 1% or more as rising rates hurt securities prices.
Bank loans are cousins of high-yield bonds, which are debt of below-investment grade companies. High-yield funds currently yield 7.6%. So why bother with bank loan funds? While the bank loans are adjustable, high-yield bonds are fixed-rate instruments that can lose value when interest rates rise. In addition, bank loans are considered safer because they represent senior debt. In the event of a bankruptcy, owners of bank loans would be paid before investors in high-yield bonds.
During the downturn of 2008, bank loans were clobbered. With hedge funds and other leveraged investors dumping portfolios, bank loan funds lost 29%. Since then markets have revived. During the past year, the funds returned 32%.
In the depths of the downturn, the loans traded at huge discounts, often selling for 60 cents on the dollar. After the big rally of recent months, the loans still sell at a slight discount to their fair value, figures Craig Russ, a manager of
Eaton Vance Floating Rate
. He estimates annual default rates of 5%. So investors who pay 95 cents on the dollar for loans should about break even after defaults. But loans currently sell for about 92 cents.
To own one of the most conservative bank loan funds, consider
Franklin Floating Rate
, which has returned 2.6% annually during the past five years, outdoing 61% of competitors. Portfolio manager Richard Hsu focuses on higher-quality names. That helped the fund lose less than competitors in 2008.
Hsu concedes that his conservative choices can trail in a bull market. But he says his goal is to help investors limit volatility. "We want to hit singles -- and avoid striking out," he says.
Franklin has most of its assets in loans rated BB, the highest in the below-investment grade universe. Hsu rarely holds many issues rated CCC, which come with more default risk.
Another careful fund is Eaton Vance Floating Rate, which returned 3.1% annually during the past five years. Manager Craig Russ says he focuses on the safer half of the loan market. "We like larger companies that can survive credit cycles," he says.
A big issuer in the portfolio is
, a cable-television company. Charter has reliable revenue because subscribers make monthly payments, Russ says.
A fund that outperformed during the downturn in 2008 is
MainStay Floating Rate
, which has returned 3.3% annually during the past five years. Worried that lenders were lowering their standards, manager Robert Dial began avoiding financial issuers and moving to higher-quality names in 2006. That helped protect shareholders when the credit crisis unfolded.
The MainStay fund remains cautious, focusing on issuers with strong cash flows. A big issuer in the portfolio is
Community Health Systems
, an operator of hospitals in rural areas. "They tend to be the only game in town and are less susceptible to competitive pressures," Dial says.
Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.