U.S. Treasury yields are at record lows with no relief in sight, causing financial advisors to search for new sources of yield. One popular alternative strategy has been “floating rate” funds that invest in short-term bank loans made to leveraged companies. These floating rate bank loans are often pegged to Libor and their rates are reset frequently––typically every three months or less. Their short duration and variable rates that “float” when market conditions change can help protect against rising interest rates.

And from an income perspective, the collective group of bank loan mutual funds tracked by Morningstar Inc. sports an appealing current SEC yield of 4.5 percent (as of January 31).

That said, there are obvious risks associated with lending to highly leveraged companies. “Bank loans have little interest rate risk, but they do have credit risk,” says Sarah Bush, a senior mutual fund analyst at Morningstar. “Most companies seeking bank loans are below investment grade.”

Bush notes that fund flows into the floating rate space gained steam last August and have remained strong with $3.6 billion in inflows in the third quarter, $6 billion in the fourth quarter, and $4 billion this past January. “Any time people get worried about rising rates, they start looking at bank loan funds,” she says.

“These funds are something that would do well in a growing economy with a rising inflation rate,” she continues, noting that a healthy economy helps these companies increase sales and cash flow, while the reset in interest rates helps protect against rising inflation.

But bank loan funds can incur losses during rough patches for the economy and the stock market. “Its really important that potential investors in these funds assess their level of patience in riding through volatility,” Bush says, adding that this asset class lost 30 percent in 2008 and dipped 4 percent during the market swoon of August/September 2011.

Christopher Graff, principal and director of asset management at RMB Capital Management, a Chicago-based investment advisory firm, says that bank loan funds tend to perform well in periods of fundamental strength in the credit markets.

“They also generally perform well when short-term interest rates rise on an absolute basis, particularly relative to other fixed income sectors,” he says.  

Graff says he’s reviewing his current allocation to bank loan funds. “Generally speaking, within our opportunistic fixed income allocation—that is, the riskier portion of our fixed income allocation—we currently allocate 15% of it to these types of funds,” he says. “This allocation is roughly in line with our historical average level, but we are actively considering increasing their weight.”

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