A portfolio's risk-adjusted rate of return improves when floating-rate senior loans are added to T-bills, bonds and stocks, according to a working paper led by Kam Chan, finance professor at Western Kentucky University, Bowling Green. The paper, "Bank Loan Funds: Investing Beyond T-bills," assumes that an investor initially invested 100% in T-bills, with bank loan open-end mutual funds and other assets added to the mix with return requirements ranging from 5% to 10% for the years 1990 to 2005. As return requirements rise, bank loan fund allocations rise and standard deviations fall. But to obtain portfolio returns of substantially more than 8%, higher allocations to equities and high-yield bonds are necessary.

Craig P. Russ, co-manager of the Boston-based Eaton Vance Floating Rate Fund and the Eaton Vance Floating Rate Advantage Fund, believes that today's market should follow historical business cycle norms. Credit fundamentals continue to improve and loan defaults are below average.

"Companies in our marketplace have experienced six consecutive quarters of revenue and profit growth," Russ says. "Cash flows are up substantially over a year ago. Default rates are under 2% after peaking at 11% in 2009."

Dial, of Mainstay, says the market for senior loans looks appealing today. Many loans are priced at par and the best credits are trading at a premium. He believes interest rates are likely to rise next year. So longer duration bonds could lose money. But floating-rate funds can be one way to get enhanced yield over a Treasury bond or a high-grade corporate fixed-income investment without extending duration.

"We have a positive view of where credit spreads are today, as well as the prospects for the floating-rate asset class over the next year," Dial says. "As measured by the trailing-12-month default rate, the leveraged loan market continues to improve. Contributing to the improvement is the fact that many of the most troubled issuers already have defaulted, while improved market liquidity has helped others remain solvent."

Dial steers the fund into higher quality 'BB'-rated loans. Companies such as Community Health Systems Inc., Health Care Corporation of America, Celanese Corp. and Graham Packaging have good cash flows and a history of high debt coverage ratios.

Russ, of Eaton Vance, also favors 'BB' and 'B'-rated credits that have strong cash flows and debt coverage ratios. He took advantage of cheap loan prices during the market collapse to add to his positions in strong companies. He's also invested in well-managed companies that have less stringent loan covenants, such as J. Crew, the clothing retailer; NBTY, a large vitamin manufacturer; and CommScope, a coax and fiber cable company.

Dial and many other fund managers also have small positions in these types of investments, which are called "covenant lite" senior floating-rate loans. Published reports indicate that these loans make up about 25% of the market.

The largest holdings of Eaton Vance's two senior loan funds include companies with inelastic demand for their products and services, such as Community Health Systems, Hospital Corporation of America, UPC Broadband, Charter Communications Operating and SunGard Data Systems.   

Most senior loan mutual funds, such as Mainstay and Eaton Vance, have larger positions in companies that have bank revolving lines of credit. And the funds review loan covenant contingencies quarterly to make sure the firms adhere to cash flow and debt coverage guidelines. Collateral tends to be hard assets like inventory, receivables or subscriber values in the wireless communication industry.