Bank-Loan Funds Offer Steady Returns

NEW YORK ( TheStreet ) -- Although most bonds have sunk lately, bank-loan funds stayed afloat.

This year PowerShares Senior Loan Portfolio ETF ( BKLN) has returned 2.4%, compared to a loss of 2.3% for the Barclays Capital U.S. Aggregate bond benchmark, according to Morningstar.

Investors have taken notice, pouring $3.7 billion into the ETF this year, according to IndexUniverse.com.

The PowerShares ETF pays an attractive yield of 4.6%. If the economy avoids falling into recession, the fund seems poised to deliver returns of at least 4% to 5% in the next year. That could be a healthy result compared to what most bonds will deliver.

Bank loans have long been favored by investors seeking ways to diversify portfolios. Because of their unusual structures, the loans have little correlation with Treasuries or other high-quality bonds. The funds typically invest in loans that have been made to borrowers with below-investment grade credits. During periods of rising rates, most bonds sink as investors sell existing issues with low yields. But loans avoid trouble because they offer adjustable rates. As rates rise, borrowers must pay more, and yields on loan funds rise.

During most years, loan funds produce single-digit returns. In hard times when investors worry about defaults, loan prices may dip, and returns can be skimpy. But most often, prices soon recover. With investors unnerved by the European crisis, loan prices softened in 2011. For the year, bank-loan mutual funds returned 1.6%. But the next year, prices rebounded, and the funds returned 9.4%. During the turmoil of 2008, leveraged hedge funds dumped loans at depressed prices. For the year, loan funds lost 29.7%. In 2009, the funds rebounded from the losses, gaining 41.8%.

Bank loans tend to be more stable than high-yield bonds, which are issued by below-investment grade companies. The loans are backed by collateral, such as real estate or equipment. In the event of a default, the owners of loans must be paid first, while investors in high-yield bonds wait at the end of the line.

On average, 3% of loans have defaulted annually, compared to 4.8% of high-yield bonds. With the economy recovering, the loan default rate is currently running around 1.4%.

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