Loan funds may be a low-risk option for your clients.

Bank loan funds, adjustable rate mortgage funds and adjustable rate preferred stock may be just the prescription the doctor ordered to snare higher yields in a rising-rate environment with very limited price risk.

"Floating or adjustable rate investments may be a good place to park short-term cash to earn higher yields," says Scott Berry, analyst for Morningstar Inc. "But financial advisors need to be aware that these investments are not risk-free."

The greatest risks in the adjustable rate fixed-income market are credit risk and mortgage prepayment risk.

Bank loan funds invest in senior secured debt of lower-credit-rated companies and are backed by collateral of the company. At this writing, they are yielding more than 3%. Rates typically are reset quarterly, based on the one-month to three-month London Interbank Offered Rate (LIBOR). Bank loan funds carry an average credit quality rating of B and a duration of 1.7 years. The funds sport a beta value of -.07 to the Lehman Brothers Aggregate Bond Index.

Bank loan funds enjoyed a banner year in 2003. The funds gained 10.4% on average, due to strong demand and a short supply of new issues as corporate America was deleveraging. For the year ending in May, the funds are in the black. They have not had a single down year over the decade ending in 2003, according to Morningstar. And in 1994 when the Fed aggressively hiked rates, the Lehman Brothers Aggregate Bond Index lost -3% but the average bank loan fund gained 6.6%.

"The floating rate nature of bank loans make them less vulnerable to rising interest rates," Berry says. "Moreover, their lower quality profile allows them to benefit from improving economic conditions. These funds should fare well in a rising interest rate environment. They could prove to be a diversifier for an interest rate sensitive bond portfolio."

Last year, investing in bank loans was like shooting ducks on the pond. Low rates spurred a strong demand for bank loans. This year is a little different. Interest rates are on the rise. The Fed was expected to hike the Fed funds rate 25 basis points in mid-year. New issuance has increased, but demand remains strong. Most bank loans are selling at a premium to par, so fund managers say the total returns for the year will most likely equal their yields.

Payson Swaffield, co-manager of Eaton Vance's Prime Rate Reserves, believes bank loan fundamentals are good. The default rates have declined to below 2% from 7% of the market during the recession. Lower-credit-rated corporation balance sheets have strengthened. Revenues and cash flow are growing. And if the Fed increases the Fed funds rate by 300 basis points over the next 18 months, Eaton Vance's Prime Rate Reserves will yield close to 6%.

"Strong demand for loans has resulted from the relative attractiveness of the asset class," Swaffield says. "We believe that the combination of a floating rate feature in the midst of record low short-term interest rates and the improving credit profile of U.S. corporations present a strong case for investing in bank loans."

Despite his optimism, Swaffield says he is not "stretching for yield." Currently, his fund yields 3%.

There is no free lunch with bank loan funds. In 2001 and 2002 bank loan funds gained just 1.59% and 0.64% respectively, due to the recession and a high level of defaults. The bottom decile-rated funds lost -1.26% and -2.48% in 2001 and 2002, respectively. This year, Berry says the great risk is that "there is not enough yield generated by the funds to offset any losses due to new defaults."

The majority of bank loan funds are continuously offered, closed-end funds. Investors can only redeem shares quarterly. By contrast, the open-end bank loan funds offered by Fidelity, Eaton Vance and Franklin must keep more money in cash than do their closed-end cousins to meet redemptions. The tradeoff: Holding more cash lowers the yield.

Adjustable rate mortgage (ARM) funds, which are considered ultra-short-term bond funds, invest in adjustable rate mortgage bonds. They are yielding around 3% and typically sport durations of less than one year.

On average ARM funds, like bank loan funds, have not had a down year over the past decade. ARM funds' beta values are just 0.09 to the Lehman Brothers ten-year Government Bond Index.

"ARM funds are not as subject as other mortgage funds to prepayment risk," Berry added. "They are considered a slightly higher-risk alternative to money market funds."

ARM funds, however, are not risk-free. Fund managers can't just buy and hold ARMs. They must make portfolio changes to avoid bonds with mortgage prepayments. Plus, they must respond to changes in interest rates.

For example, in 2003 the AMF Adjustable Rate Mortgage Fund had to deal with rapid mortgage prepayments. So the fund reduced its holdings in GNMA ARMs that traded to high premiums. Similarly, the fund increased its holdings in lower dollar, cost-structured ARMs. It also increased its holdings of AAA-rated nonagency securities to diversify its credit profile.

Now that interest rates are on the rise, Jon Denfeld, co-manager of the fund, says he is still defensive. He has invested 60% of assets in six-month ARMs tied to the six-month LIBOR. As rates rise, the mortgage pools within the bonds are reset monthly until the bonds' rates are fully reset in six months. As a result, the duration of his fund is now just one-third of one year. At this writing, the fund was yielding 2.25%. But it was expected to rise another 100 basis points if the Fed raised rates.

"Only time will tell if rates will rise rapidly on the forward curve," he says. "It is difficult for us to change the portfolio on a dime, but this portfolio is structured defensively."

Another option: Adjustable rate preferred stock (ARPS) pays quarterly dividends tied to the U.S. Treasury bill rate. In the event of a bankruptcy, preferred stockholders get paid before common stockholders, but after bondholders.

Thomas Grzymala, an Alexandria, Va.-based CFP licensee, says he would consider high-quality adjustable rate preferred stock if there is a strong interest rate trend. "I have not used them yet," he says, "but with rates changing, they are a desirable vehicle for an income portfolio. I would also diversify into REITs and GNMA bonds."

Others say institutional investors either are creating short-term bond ladders or investing based on the shape of the yield curve rather than parking cash in adjustable rate investments. "Adjustable rate preferred could be a small part of a portfolio," says Thomas Scharski, vice president of institutional sales with the Cambridge Group, East Lansing, Mich. "Their yields are too low based on the credit risk. Investors are concentrating on bonds. They are higher in the pecking order and there is less credit risk."

Jack Colombo, editor of incomesecurities.com, says the 2% yields on adjustable rate preferred stocks are not worth the price. "Interest rates would really have to jump for ARPS (adjustable rate preferred stock yields) to rise," he says. "Many have caps that limit how much they can pay."

Colombo recommends that advisors diversify bond portfolios by investing in high coupon preferred stock. The higher coupon issues will decline less in value as interest rates rise.

Colombo also recommends the closed-end Flaherty & Crumrine Preferred Income Opportunities Fund. The fund yields 7.8%, and 65% of assets are invested in adjustable rate preferred stock and fixed-rate preferred, some of which are hedged.

On the adjustable rate mortgage side, Morningstar's Berry says that investors should avoid investing in individual adjustable rate mortgage bonds. They are better off in a diversified mutual fund. The reason: ARM prices can decline if interest rates rise quickly, particularly on bonds with interest rate caps. In addition, there is some prepayment risk if homeowners refinance their mortgages.

"If rates rise quickly, there are adjustable rate mortgage bonds with rate caps that do not track with rates," he said. "Last summer the AMF and Evergreen funds declined in value when interest rates spiked."