(Dow Jones) The economy is showing more signs of sluggishness, interest rates are at a one-year low and the word "deflation" is being uttered by economists with alarming frequency.
Is it time to bet the other way?
For bond investors who are skeptical of the deflation scenario, a category of mutual funds called floating-rate funds might be the answer. The funds, which buy corporate loans, are structured so that if interest rates rise, they collect more money.
If you are among the inflation hawks, then the time to get into floating-rate funds is now, before rates start to rise, says Eric Jacobson, director of fixed income research at Morningstar Inc. Once that happens, investors will flock to the funds, driving down yields and driving up prices.
Look beyond the recent turmoil and many signs point to higher interest rates in coming years. Central banks around the world have flooded their economies with money. And with governments now struggling under the weight of enormous debt loads, they might be tempted to fire up the monetary printing presses even more to devalue their debt. That could stoke inflation pressures world-wide.
Such a scenario would put traditional bond investors in a bind. Picking the right moment to sell out of bonds before inflation surges isn't easy -- a lesson that investors holding bonds in 1994 and 2003 learned all too well.
Enter floating-rate funds. Also known as "bank loan" funds, they buy variable-rate bank loans made to corporations, typically ones with noninvestment-grade, or "junk," credit ratings, such as HCA Inc., Community Health Systems Inc. and Georgia-Pacific LLC. The bonds' main advantage: If interest rates rise -- and many expect them to start rising sometime next year -- borrowers pay a higher rate, resulting in a higher yield to fund investors.
Thanks to the recent fall in interest rates, bank-loan managers are finding better values now. "After May's drop in loan prices of about 2% to 3%, they're even more attractively priced," says Craig Russ, a portfolio manager at Eaton Vance Corp., which holds about $18.5 billion in retail, institutional and closed-end floating-rate funds. The typical floating-rate funds is currently yielding about 4% to 5%, much better than the 0.7% on the Barclays 1-3 Year Treasury index or the 1.4% on the Barclays 1-3 Year Aggregate bond index.
When a company defaults on a loan, the consequences often aren't dire for investors. Bank loans are generally secured and senior -- meaning they are backed by the borrower's assets and holders must be repaid before holders of stock or unsecured debt. That results in higher recovery rates for loan holders.
A bigger risk is falling interest rates. Battered by the financial crisis, bank-loan funds lost 29.7% in 2008, although they rebounded 41.8% last year, according to Morningstar. So far this year, floating-rate funds are up 2.9%. Given the big swings, floating-rate funds should be viewed as a complement to -- not a replacement for -- investors' core bond holdings, advises Morningstar's Mr. Jacobson.