Higher rates and negatively correlated returns win advisors' attention.

Funds that invest in variable rate loans to below-investment-grade companies may sound like a gamble, but it's one that an increasing number of financial advisors worried about the impact of rising interest rates are willing to take. As their name implies, bank loan funds invest in loans packaged and issued by banks and other financial institutions. Companies typically use the loans to finance mergers, acquisitions and leveraged buyouts.

Their variable rate changes every few months and is usually pegged to the London Interbank Offered Rate (LIBOR) or the certificate of deposit (CD) rate. Investors concerned about rising interest rates like the funds because when the rates on portfolio loans rise, fund yields will follow suit soon after. As short-term rates decrease, interest payable to the fund will go down and its yield will drop. Although the stated maturity of the loans may be as long as eight years or more, many companies refinance them long before that with lower-cost bonds or equity.

Because they invest in variable rate loans, bank loan funds have a very low level of interest rate risk, as well as a low correlation to other fixed-income investments. Over the last ten years, bank loan funds have had a -0.12 correlation to the Lehman Aggregate Bond Index and a .50 correlation to high-yield bonds. Recognizing their emergence as an asset class with its own unique characteristics, Morningstar created a separate category for them in June. The funds also offer heftier yields-which currently range from about 2.5% to 5.5%-than investments with similar durations.

While bank loan funds have minimal interest rate risk, they do carry credit risk because most of the borrowers they invest in have below-investment-grade credit ratings. When default rates soared in 2001 many of the funds, particularly those with a heavy presence in fragile telecommunications companies, posted slightly negative returns. The group continued to struggle in 2002 against the backdrop of a weak economy.

Still, considering the severity of the credit environment over the period, floating-rate loans held up reasonably well. The fact that the loans are usually collateralized, and are senior to bonds and stocks in a company's capital structure, undoubtedly kept them from suffering larger losses. Over the ten years between 1993 and 2003, in fact, the CSFB Leveraged Loan Index experienced just 18 months of negative total returns, with an average loss of 0.79% for those down months.

Despite the resilience of bank loan funds in one of the worst credit downturns in history, liquidity remains an issue. Many of the funds only allow redemptions on a quarterly basis. And even though fund sponsors have been able to meet redemptions so far, they reserve the right to place a ceiling on the percentage of fund assets investors can cash out.

More recently, however, new redemption features and an improving economic picture have given the asset class new appeal. Some funds now allow daily redemption of fund shares (although some share classes still have exit fees). Performance also has improved thanks to rising interest rates, fewer loan defaults and an increasing number of credit upgrades. Over the last year, some funds have risen from around 5% to nearly 20%, depending on their portfolio investments.

Bank loans are also shedding their frontier reputation as the market becomes more standardized. Until about ten years ago, the syndicated loan market was a private, inefficient segment consisting of credit relationships between banks and corporations. A secondary market began to develop when banks began syndicating the loans to outside investors, and in recent years the secondary market for commercial lending has become more transparent and disciplined.

But perhaps the most appealing attribute of bank loan funds right now is their resilience in a rising rate environment. "With GDP growth coming in stronger than many people expected, I don't think its out of the question that, at some point, interest rates will start going up again," says Scott Page, who co-manages several bank loan funds offered by Eaton Vance, one of the first firms to bring this asset class to the retail market in 1989. "When that happens, we won't be taking the huge losses that traditional fixed-income funds face." An improving economy and fewer defaults, he adds, would give the funds an added boost.

Different Strategies, Different Returns

Like managers of any fixed-income fund, the folks who run variable bank loan funds want to make sure that a company can pay its debt. "We look for a history of verifiable cash flow and evidence of an ability to repay debt in a predictable way," says Page. "We also look at what would happen if a company gets into trouble. If it has multiple divisions, for example, it could sell one of them to pay the loan. An ability to access other capital markets is also a plus."