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."

Anthony Clemente, who manages the AIM Floating Rate fund, evaluates the reputations of the private equity sponsors that have large stakes in many of the companies that tap the bank loan market to make acquisitions. He also looks at industry positioning, asset quality and the ability of a company to sell off parts of itself to repay its debt. He prefers larger-capitalization loans of $200 million or more because of their superior liquidity. A growing number of the loans he invests in are in service sectors such as chemicals and transportation, which stand to benefit from a cyclical economic recovery.

Differences in management strategies mean that returns, particularly over short periods, can vary dramatically between funds. Factors that influence performance include:

Credit quality. While most bank loan funds focus on below-investment-grade credits to boost yield, some gravitate toward the better-quality end of the junk spectrum. Others prefer to take a somewhat higher degree of credit risk, including some investments in distressed companies, to achieve higher returns. Managers may become more aggressive in their credit stance if they see an economic rebound on the horizon, or they may gravitate to more conservative credits when defaults are on the rise.

Page generally prefers a more conservative strategy. "This is not the best asset class to take a high-risk, high-return approach," he says. "The point of investing in bank loans is to get a little extra yield and good protection against downside risk."

Sector allocation. In 2002, funds that invested heavily in loans to telecommunications companies lagged more conservative peers that positioned themselves in defensive sectors such as health care. So far this year, a rebound in the telecommunications industry and a strengthening economy has put those former laggards ahead.

"People were in a panic about weakness in the telecommunications industry," says Derek Schug, director of investor services at Columbia Management Group, which offers two bank loan funds that have invested in that sector more heavily than many of their peers. "But we recognized the underlying value of telecommunication company collateral assets." He adds that loans in wireless are less volatile than the sector's bonds or stocks, and that the fund balances out aggressive positions in the media and telecommunications sectors with loans in more defensive industries such as health care and food.

Leverage. Some funds use leverage for investment purposes, while others do not. As with other types of investments, the strategy is a double-edged sword. If the investment performance falls short of borrowing costs, the fund's shares could decrease in value more rapidly than in a nonleveraged fund, and dividends on the shares would be reduced or eliminated. On the other hand, the value of fund shares would rise and dividends would increase if the return from the bank loans exceeds the cost of borrowing. Although leverage increases risk, its impact is more muted than it would be in a strategy involving stocks or bonds because rising yields on the variable-rate portfolio loans offset higher borrowing costs.

The difference in returns between the Columbia Floating Rate Fund and the Columbia Floating Rate Advantage Fund illustrates the impact of investment borrowing in a bank loan fund. While both have essentially the same portfolios, the latter fund's use of leverage boosts its current yield to 5.53%, compared with 3.93% for its nonleveraged sister. But when default rates peaked in the third quarter of 2002, the nonleveraged fund's net asset value declined by 4%, compared with a 6% decline for the leveraged fund. Rising yields and improving credit quality combined to help produce a total return of 11.29% for Columbia Floating Rate Fund during the first three quarters of 2003, compared with a leverage-amplified return of 15.73% for Columbia Floating Rate Advantage.

Bonds in the portfolio. Some bank loan funds try to spice up total returns by adding high-yield bonds to the portfolio mix, while others focus solely on bank loans. Eaton Vance Floating Rate High Income Portfolio, for example, devotes 15% of its assets to high-yield bonds.

Opinion differs about whether redemption features influence returns. Schug and Clemente maintain that funds that limit redemptions to four times a year, as theirs do, have a built-in advantage because they need to keep less low-yielding cash on hand to meet redemptions than funds that allow investors to cash out every day. Page of Eaton Vance calls that observation "absolute bunk." He says that the higher quality of the loans in the portfolio, not higher cash levels, account for his funds' slightly lower yield compared with competitors with more restrictive redemption features.

Floating Rate Bank Loan Funds

The firms below offer floating rate bank loan funds:

Columbia-(800) 345-6611; columbiafunds.com

Eaton Vance-(800) 225-6265; eatonvance.com

Fidelity-(800) 343-3548; fidelity.com

Franklin-Templeton-(800) 632-2301; franklin-templeton.com

ING-(800) 992-0810; ingfunds.com

Merrill Lynch-(800) MERRILL; ml.com

Morgan Stanley/Dean Witter-(212) 761-4000; morganstanley.com

Oppenheimer-(888) 470-0862; oppenheimerfunds.com

SunAmerica-(800) 858-8850; sunamericafunds.com

Van Kampen-(800) 421-5666; vankampen.com