Banking on Prime Rate Funds

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