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.