Banking on Prime Rate Funds

March 1, 2004 -- If interest rates start creeping up this year, bonds are likely to suffer. But one type of fixed-income investment -- bank loan mutual funds -- could serve as an alternative.

Bank loan funds, also known as prime rate or loan participation funds, invest in senior secured loans made by banks and other financial institutions to big corporations. The interest rates are usually tied to the London Interbank Offered Rate (LIBOR) and reset every 30 to 60 days. Because of that feature, the loans' value tend not to decrease when interest rates increase.

"Right now, they're a good way to hedge interest rate risk," Steven Miller, a Standard & Poor's managing director, said of prime rate funds. Miller is with the company's leveraged commentary and data unit, which compiles statistics on the bank loan market.

Bank loan funds returned 6.5% on average in 2003, while the average high-quality bond fund gained 4.5%, according to Standard & Poor's data. High-yield bond funds, which hold comparatively riskier securities, were up 23.2%.

The bank loan market itself strengthened last year, partly because of a decrease in default rates, which fell to 2.3% from 6% in 2002, Miller says.

The decline helped lure investors back into bank loan funds in 2003 after rising failure rates scared them off the previous three years, observers said. Open and closed-end bank loan funds attracted about $1 billion in new cash last year after hemorrhaging $5.5 billion in 2002, $5.2 billion in 2001, and $643 million in 2000, fund tracker Financial Research Corp. reported.

Another advantage of bank loan funds is their low correlation to other asset classes, which means they can provide a cushion when stocks fall. "That tends to make them a very potent diversification tool," said Scott Page, who helps manage several bank loan funds offered by Eaton Vance, which was one of the first firms to begin selling these products in 1989. (Most of the open and closed-end prime rate funds available now went into operation in the late 1990s.)

Despite their low interest risk, the funds carry credit risk because they invest in securities rated below investment grade.

That drawback is somewhat offset, observers said, because the loans are secured by assets, so holders stand to recoup something if the loans don't get paid off. The recovery rate on bank loans between 1988 and the third quarter of 2003 stood at 77.5%, Standard & Poor's data shows. The rate eased to 74.1% between 1998 and 2002, when the stock and bond markets were under stress at various times. Over all, rates have been been declining since the mid 1990s, but the cause of the decrease is not known, said David Keisman, a managing director with a Standard & Poor's unit that amasses statistics on bank loans and other debt instruments.

Page and Anthony Clemente, who helps manage the institutional Aim Floating Rate fund, said they both want to make sure that companies can repay their debts. Beyond that, Page said he looks for "good, solid collateral," so that he can recover something if a loan defaults.

Loan holders benefit, too, because they get paid off before investors who own bonds or stocks when a company has to restructure, observers noted.

Liquidity can also be a problem with bank loan funds. While some now allow investors to sell shares daily, many permit redemptions only once per quarter or once per month.

Bank loans themselves are becoming more liquid, said Brian Mitchell, a product manager for bank loan funds offered by Aim Funds. There is more secondary trading of these loans and the size of blocks of loans that change hands has risen in the last five years, he said.

Fees are another concern when considering whether to invest in a bank loan fund. Expense ratios for retail funds over the last 16 months ranged from 0.84%-1.87%, and averaged out at 1.36%. By comparison, the average for all fixed-income funds was 1.05% last year.

Nor are bank loan funds a substitute for safer, but low-yielding money market funds or certificates of deposit, said Louis Stanasolovich, a financial planner in Pittsburgh who has written about prime rate funds. "They're definitely not at the same risk level" as those competing investments, he said. But he feels bank loan funds are "probably likely to perform the best if interest rates rise."

-- Richard Diennor

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