Getting Fatter Yields with Bank Loan Funds

NEW YORK ( TheStreet) -- Chairman Ben Bernanke boosted the outlook for most stock and bond mutual funds yesterday when he announced that the Federal Reserve would keep interest rates low until 2015. But investors in bank loan funds had less reason to cheer Bernanke's news. The loan funds rank as one of the few fixed-income assets that thrive during periods of rising rates. When rates sink, the funds can appear less attractive.

Should you stay away from the loan funds? Not necessarily. According to Morningstar, the average loan fund yields 4.2%. That's an intriguing payout at a time when 10-year Treasuries yield 1.78%. In addition, a small position in loan funds can serve as an insurance policy, protecting portfolios against the risk of a sudden spurt in rates.

If rates remain low and the economy continues sputtering along, investors in the funds could obtain decent annual returns of 4% to 5% in the next several years. The risk is that the economy could slip back into a recession. If that happens, investors could worry about loan defaults, and the funds could sink into the red. Lately the risk of defaults has seemed low. Only about 1% of loans have been defaulting annually, well below the average historical rate of 3.6%.

The loan funds invest in adjustable rate debt. When rates rise, the yields on the loans also climb. That is why the funds are resilient in periods of climbing rates. In contrast, conventional bonds pay fixed rates. When rates rise, the values of most fixed-income investments tend to fall.

The bank loan funds invest in debt from companies with below-investment grade credit. Because of the shaky credit, bank loans yield more than investment-grade corporate bonds, which currently yield around 3%.

Bank loans yield less than high-yield bonds, which are also rated below investment grade and yield around 7%. The loans have skimpier payouts because they are considered safer. In the event of a bankruptcy, the loans must be paid first with the borrowers' assets. Investors in high-yield bonds must stand at the back of the line to see whether they recover anything.

To limit risks, consider one of the tamer bank loan funds. These emphasize bonds rated BB, the highest level in the below-investment grade universe. More aggressive loan funds focus on bonds that are rated B or lower.

The cautious funds have outperformed peers during downturns. A solid choice is Fidelity Floating Rate High Income ( FFRHX). During the past five years, the fund returned 4.8% annually, outdoing 91% of peers. While the average fund in the category has only 40% of assets in loans that are rated BB or higher, Fidelity has 59% in the higher ranks. Besides emphasizing higher quality securities, portfolio manager Christine McConnell also prefers loans made to large companies, since they are less likely to default.

The cautious stance helped limit risk during the turmoil of 2008. While the average bank loan fund lost 29.7% for the year, Fidelity dropped 16.5%. McConnell concedes that her fund can lag during rallies when investors bid up prices of shaky securities. But she argues that the steady approach can excel over a full market cycle. "We want to at least match our competitors while taking much less risk," she says.

Another steady performer is Pioneer Floating Rate ( FLARX), which has returned 4.4% annually during the past five years, surpassing 77% of peers. The fund has 62% of assets in securities that are rated BB or higher. Besides emphasizing higher-quality issues, portfolio manager Jonathan Sharkey aims to limit risk by holding loans that come with tight covenants. These permit investors to obtain more favorable terms if borrowers fail to perform as planned. "The covenants enable investors to recover more if borrowers run into trouble," says Sharkey.

A fund that excelled in 2008 is RidgeWorth Seix Floating Rate High Income ( SFRAX). During the past five years, the fund has returned 4.5% annually, outdoing 83% of peers. Lately portfolio manager George Goudelias has been shifting into BB loans. "Until there is a strong economic recovery, it is prudent to have a little more exposure to the better quality investments," says Goudelias.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.