Prime Rate Funds: Ready For Prime Time

Money-market funds preserve your principal, but the yield is low: only 4.6% over the last 12 months. If you could live with a little fluctuation in net asset value (NAV), however, you could earn two percentage points more yield. That's the pitch for "senior loan" or "prime-rate" funds.

You won't find them at the no-load fund companies. Eaton Vance and Van Kampen Investments are among the big players. There are no up-front loads, but sales charges are levied via higher expenses. Even with a 1.4% average expense ratio, yields are still appealing because they're reported net after expenses.

These funds buy pieces of loans that banks make to major corporate borrowers. The interest rate resets every three to six months at a fixed amount--now an average of about 2.6% over the rate that international banks pay on overnight loans. So the funds are sheltered from principal loss due to rising rates. That means there's not much change in NAV. Since 1989, shares of Eaton Vance Prime Rate Reserves Fund have ranged between $9.95 and $10.07.

Of course, you don't get extra yield without any risk. The loans are made to companies whose bond ratings are below investment grade. But unlike junk bonds, the loans are secured by corporate assets, such as accounts receivable, inventories, and properties. And they're "senior," meaning lenders get paid before bondholders. "Until the secured creditors are finished eating, no one else gets a bite," says Scott Page, who, with Payson Swaffield, manages senior loan funds for Eaton Vance.

To mitigate trouble with any one creditor, the funds diversify. Eaton Vance, for instance, has 364 companies in 66 industries. And there have only been 15 defaults in its 10-year life. But even then, the fund has recovered about 80% of what was owed. "We've been tested and we know it works," says Swaffield.

HIGHER YIELDS. Prime-fund investors have to give up some liquidity. You can put money in any time, but you can withdraw it only quarterly. That's because the funds' investments cannot be immediately turned to cash.

Those who want liquidity can buy an exchange-traded closed-end fund--Eaton Vance Senior Income Trust, Pilgrim Prime Rate Trust, Travelers Corp. Senior Loan, or Van Kampen Senior Income Trust. These funds can be sold anytime, but not necessarily at NAV. Pilgrim recently traded at a 4% premium, but Travelers was at a nearly 7% discount.

The closed-ends also leverage their portfolios, so they offer higher yields. In either format, prime-rate funds look like the nearest thing to a free lunch: a high return with just a bit of risk to your principal.

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