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%.

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