Prime Time For Prime-Rate Funds

These funds can help protect you against the risk of higher interest rates.

Interest rates are already well up from their 45-year lows, and with the economy improving, they are unlikely to head back down. That makes long-term bonds and bond funds, which decline in price when rates rise, a bad bet. Meanwhile, the Federal Reserve has kept short-term rates so low that money-market funds yield less than 1% -- hardly an attractive solution for the income-starved investor.

That means it's prime time for prime-rate funds. Also known as bank loan funds, these portfolios are comprised of loans made to corporate borrowers that are pegged to the prime lending rate, now 4%; the rates on the loans are usually prime plus 3% or so. That means the funds' yields rise along with rates.

What's more, the loans they invest in become more valuable as borrowers' creditworthiness improves with a rising economy. "In the past three years, it has paid to be in bonds with higher credit quality," says Payson Swaffield, who with Scott Page, manages $10 billion in bank loan funds for Eaton Vance Management. "Now, with the economy slowly improving and default rates declining, the greater risk is that of rising interest rates."

Consider what happened back in 1994 when interest rates spiked. Long-term Treasury bond funds lost 6.9%, but prime-rate funds gained an average 6.6%, according to Morningstar. The group has averaged returns of 3.8% a year over the past five years (through Sept. 30) of low rates and recession, vs. 5.6% a year for long-term Treasury funds, and 5.4% a year for corporate bond funds. But prime rate funds beat money-market funds, which earned 3.4% a year.

Investors don't need mutual funds to buy T-bills or bonds, but for most, a prime-rate fund is the only way to invest in the $1 trillion senior floating-rate loan market. These loans generally are made by banks to companies to finance buyouts or acquisitions. The loans are rated by credit agencies such as Moody's and Standard & Poor's. They're then bundled, or syndicated, in the secondary market. Buyers are usually endowments, hedge funds, and, of course, mutual funds.

The borrowers behind these loans are not the most creditworthy. They're usually the same companies which, when they go to the bond market, are issuers of junk bonds. Still, there's less risk in these loans than investing in junk bonds. The loans are classified as senior or secured loans as opposed to unsecured or subordinated bonds. That means if a company gets into trouble, and its assets are liquidated, the holders of the senior debt will be paid before other investors. "We are basically in a favored position," says Eaton Vance's Scott Page.


In any of these funds, diversification is a critical element. The Liberty Floating Rate Fund is up 11.6% so far this year, and more than half of that comes from price appreciation. Co-manager Brian Good owns loans of 161 different companies in 46 industries, and the average stake he has in any one position is less than 1% of the fund's assets. Good's returns have been helped by improving fundamentals in two main industries this year: cable TV and wireless telecom, especially in some core holdings, such as Nextel Communications (NXTL ), Centennial Cellular (CYCL ), American Cellular, Adelphia Communications, and Charter Communications (CHTR ).

Some bank loan funds are closed-end. Such portfolios invest like funds, but their shares trade like stocks. That means their market prices usually differ from the underlying value of the holdings. Those funds are good buys when their market price is at a discount to their net asset value. But unfortunately, that's not generally the case right now. These shares are up 25% year to date, and most of the closed-ends trade at premiums. That's why UBS (UBS ) analyst Jon Maier downgraded the closed-end funds to neutral this summer, after the group soared 25% in market price. "They've had a great run," he says, adding, "but it's still a good yield play and a good hedge against rates."

There are downsides to investing in bank loan funds. Often, they are expensive and sold with deferred sales charges of as much as 3%. And ongoing expenses can also be a concern -- most are well above 1%. That's high for an income fund. Still, returns are reported net of expenses, so if you're satisfied with them, the funds can be a good deal.

Bank loan funds were laggards during the bust. The yields came down as the Federal Reserve kept lowering interest rates. Their credit quality deteriorated along with companies' fortunes -- and that eroded their portfolios' net asset values. Prime-rate funds are not an optimal investment for all times. But with an improving economy, they are definitely coming into season.

By Mara Der Hovanesian

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