To watch a video presentation on this report from reporter Gregg Greenberg, please click here.

After a healthy 2004, bank loan funds seem to be coming down with the same malady that's punishing the high-yield bond market.

While still up close to 1% since the start of the year, the average bank-loan or floating-rate fund has dropped 0.12% over the past month, according to fund tracker Morningstar.

The dip, however slight, makes it only one of two bond fund categories in the red for the past 30 days -- the other laggard being high-yield funds, which are down 1.39% on average.

What makes bank loan funds' recent stumble surprising is the amount of attention -- and money -- being lavished on the category so far this year. Demand has skyrocketed for bank loan funds, which boast yields that rise along with interest rates, as investors scramble for a steady payout in the face of a low-yield environment and an aggressive

Fed

. According to Lipper, a Reuters firm that tracks mutual funds, bank loan funds saw inflows of $5.5 billion in 2004, up from $1.9 billion in 2003. In the first quarter of 2005, bank loan funds took in $1.23 billion.

On the supply side, fund families have been trying to accommodate rising demand by adding bank loan funds to their rosters. New funds have recently been offered from the likes of Putnam, MFS and Pioneer.

Fund managers say the froth in the bank loan market may have been a factor in the recent selloff as some investors, chiefly hedge funds, booked profits. But they say the more likely explanation is that problems in the high-yield bond world -- like the recent downgrade of

General Motors

(GM) - Get Report

and

Ford

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debt to junk status -- are spilling over into their once-staid domain.

"They caught a cold and we got a sniffle," says Scott Page, portfolio manager for the $4.19 billion

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Eaton Vance Floating-Rate fund.

How They Work

Bank loan funds invest in loans packaged and issued by banks and other financial institutions. 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, thus making it one of the few defensive alternatives for fixed-income investors in the midst of the Fed's rate-hike kick.

Bank loan funds also offer respectable yields at a reasonable cost. The average bank loan fund 12-month yield is 3.5%, with a range of 2.5% to 5.5%, according to Morningstar. That compares with a 3.28% payout for a one-year CD, says Bankrate.com.

The average bank loan fund has an expense ratio of 1.45%, compared with 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 Page. "And since last year, they are being alerted to the problem of interest rate risk. In bank loan funds, the interest rate risk is almost zero."

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 that, as a rule, he would rather "sacrifice a slightly higher yield in favor of a company that's a better credit risk," which is perhaps why the yield on his fund is currently at 3.15%, slightly below the group average.

Boogie-Woogie Flu

While bank loan funds sound an awful 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.

Richard Hsu, portfolio manager of the $1.1 billion

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Franklin Floating Rate Daily Access fund, says bank loans are safer than high-yield bonds. That's because loans are senior in the capital structure -- bank loans get paid before bondholders get paid -- and are also collateralized by the issuer.

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.

Also, Hsu points out that there is a strong correlation between high-yield issuers and bank loan issuers, "so to the extent that high-yield bonds trade off, it's likely that bank loans will follow."

Eaton Vance's Page also attributes part of the selloff to hedge funds that used bank loan funds as a safe haven but jumped back to high-yield bonds once spreads widened against Treasuries after GM's slip-up in March.

But ultimately, the sickness that's afflicting both the high-yield and bank-loan markets is a function of their higher-than-average credit risk. That's why Morningstar analyst Scott Berry advises investors not to go overboard with bank loan funds despite their appeal in today's low-yield environment.

"Bank loan funds are a good way to diversify an interest-sensitive bond portfolio, but they are not risk-free," says Berry. "These are still low-quality bonds, and there is still the possibility of default."

To watch a video presentation on this report from reporter Gregg Greenberg, please click here.