With interest rates at historically low levels, it seems like there's no place for them to go but up. But rising interest rates would decrease the value of existing bonds. The 4% interest they already yield on the market will bring lower prices if newly issued bonds yield 5% or 6%.
Likewise, falling bond prices mean that bond funds lose value. Not all bond-type funds are heading south, though. Bank-loan funds offer a hedge against rising interest rates: They can pay higher yields and fund values can go up, too. "Bank-loan funds probably make more sense than any other fixed-income investment out there now," says Lou Stanasolovich, a certified financial planner and president and CEO of Legend Financial Advisors in Pittsburgh.
As you might suspect, these funds buy bank loans. "They buy secured, floating-rate loans that banks have made to corporations," explains Stanasolovich. "The loans have interest rates that are reset every 60 to 90 days. Therefore, if interest rates rise, the payments due on these loans will move higher and the loans will increase in value."
According to mutual fund research company Morningstar Inc., the bank-loan fund category has had positive returns every year for more than a decade. In 2003, the category's average total return was more than 10%, bringing its 10 year average up to 5.5%. As of this writing, the category's average yield was 3.7%. "These funds make sense if you want an investment that produces income, if you have a moderate risk tolerance, and if you're seeking a fixed-income investment that is less susceptible to interest rate increases," says Ben Utley, a certified financial planner in Eugene, Oregon.
But bank-loan funds do have risks. "If you want protection against rising interest rates along with higher yields than you'll earn in a money market fund, you must give up something. With bank-loan funds, you have a slight risk of capital loss," says Utley.
The loans in these funds' portfolios may have been made to corporations in less-than-stellar financial condition. Although the loans are secured, they may default, and in some cases the collateral backing of these loans is insufficient to repay the debt. In other cases repayments are delayed. Defaults, therefore, can drag down the returns of bank-loan funds.
In 2001 and 2002, when the economy staggered, bank-loan funds gained a mere 1.58% and 0.63% as a category. Some lost money in those years. But 2004 and 2005 shape up as a "perfect storm" for...