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Bank-Loan Mutual Funds May Be Good Bet

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Hey, investors: Want to buy some corporate debt?

These days, that is a prospect that most individual investors would approach gingerly, given recent high-profile corporate bankruptcies, market anxiety over telecommunications debt, and the prospect of rising interest rates, which typically decimate returns from fixed-income instruments.

But some financial advisers say bank-loan mutual funds, which buy bundles of corporate loans initially made by banks, can make investing sense, especially now. Despite last year’s corporate-debt woes, many of these funds held up well. Moreover, they also tout something of a cushion against the interest rate increases that many analysts predict are only a matter of time.

Bank-loan funds, also called prime-rate or loan-participation funds, won’t supercharge your portfolio.

But results within the group can vary greatly, depending on which company a fund holds. For example, Morgan Stanley Prime Income Trust, with $1.9 billion in assets, lost 5.92% last year — in part because of loans it held to such troubled telecom companies as Global Crossing Ltd., Teligent Inc `A` (TGNTQ) and 360networks Inc.

Nor are bank-loan funds a substitute for much safer — if low-yielding money market funds and certificates of deposit. Along with their benefits, bank-loan funds also carry their own risks. Many of the funds also have an unusual structural catch: While investors can buy shares at any time, they can only sell shares once a quarter. Some of the newer funds don’t carry such restrictions, but many older funds do.

And fees can be an issue. Retail bank-loan funds charge expense ratios that vary widely (ranging between 0.78% and 1.69% of assets a year), and some carry sales charges as high as 5%. “This is one product where the fees can really eat up your return,” says manager Ray Kennedy of Pacific Investment Management Co., which doesn’t run a dedicated bank-loan fund but uses bank-loan securities in several of its Pimco funds.

Even so, fans of the bank-loan funds say they can be a handy portfolio tool if used in modest quantities. “It’s a good diversifier,” says Pittsburgh financial adviser Louis Stanasolovich, who has studied the bank-loan category and found that its investment returns show little resemblance to those of the stock market. His firm keeps about 10% of assets under management in bank-loan funds.

Bank loan funds are a relatively new phenomenon (most portfolios are less than five years old) that developed as banks began reselling some of their corporate loans to other investors. The rebundled loans carry varying degrees of risk and return and generally fall between the quality of high-grade corporate debt and “high-yield” or junk bonds. “It’s a lower-grade bond, basically, Stanasolovich says.

But while they might look like regular bond funds, the bank-loan group incorporates some twists. For one, most bonds fall in price when interest rates rise, quickly hurting returns; bank-loan funds don’t suffer as much. The interest that corporations pay on bank loans readjusts soon after interest-rate changes, which means rising rates don’t slam the bank-loan funds. Indeed, most bank-loan funds include the phrase “floating rate” in their name to signal the feature.

“If short-term rates go up, within 60 days we are delivering a higher yield,” says Scott H. Page, co-manager of four Eaton Vance bank-loan funds, including Eaton Vance Prime Rate Reserves Fund, one of the oldest such portfolios that has been in operation since 1989. “We’re not taking interest-rate risk.”

That contributes to another feature of bank-loan funds: They don’t act like other major asset classes, with the returns of one group showing less volatility than major bond or stock groups.