High yields but high risk in bank loan funds

Bank loan funds are a bit of an odd duck in the bond world in that they don't have the traditional correlation of rates rising as prices fall and vice versa. The yields tend to rise as interest rates rise. Most of these funds are composed of below-investment-grade corporate loans that pay a high yield.

The difference between these and junk bonds is that the loans are secured with company assets and they are senior. If the company defaults, these loans may not be paid off first, but they'll be ahead of many others. But that doesn't mean they're risk-free.

"In the past, a lot of these funds were sold as money market alternatives, but they are considerably more risky," says Scott Berry, Chartered Financial Analyst, or CFA, at Morningstar Inc. "You could lose some principal. In July alone, the average fund lost 3 percent."

Most bank loan funds are closed-end funds. These differ from traditional open-end mutual funds in that a fixed number of shares are offered to the public. The shares trade throughout the day like a stock, and the price per share is determined by demand; it can be above or below the net asset value, or NAV.

Open-end funds can issue an unlimited number of shares. The NAV is determined by the prices of the stocks or bonds in the fund. Open-end funds usually keep a sizable portion of the investment in cash to pay customers when shares are redeemed.

Three investment options
Berry says there are basically three options: the true open-end mutual fund, continuously offered closed-end funds and the true closed-end fund.

The true open-end fund is the newest version of the bank loan fund, and just like any other mutual fund, you can buy and sell it every day at NAV. Berry says you'll find these funds for sale at Eaton Vance, Fidelity and other companies.

Then there are continuously offered closed-end funds. You can buy them any day at NAV plus any sales charge, but you can only sell quarterly. And finally, there is the true closed-end fund, which trades at a premium or a discount to the NAV, but is easy to get in and out of because it trades like a stock.

For example, Nuveen Floating Rate Income Opportunity Fund (NYSE: JRO) is a closed-end fund that, as of this writing, has a yield of nearly 10 percent. It recently listed its NAV at $13.45 on a day when the closing share price was $12.85. That means the shares were trading at a 4.46 percent discount.

Rapid response to rates
The reason these funds are also called floating rate funds is because the bonds represent short-term loans with terms that reset every 30, 60 or 90 days. When short-term rates are rising, lenders can raise interest rates and the funds respond quickly to the rising interest rate. Additionally the short reset period helps maintain a stable principal value.

Closed-end bank loan funds operate using leverage, which can be a problem in a slowing economy if it means companies are more likely to default on their loans. The open-end mutual funds don't normally use leverage.

William Larkin, portfolio manager at Cabot Money Management in Salem, Mass., prefers closed-end funds at this time.

"I assume no one really knows what's going to happen with the bond market, so I use these within an asset allocation with a 5 percent weighting," he says. "I like the product, this type of strategy, this type of security, because it's not very closely correlated with other bonds and it spills off some nice income.

"When we have very low short-term rates, the closed-end funds are a perfect place to be because they're borrowing very cheaply, investing that loan, and enhancing the size of their portfolio, but they're collecting much higher yields."
Yields, of course, will be lower for the open-end funds that don't use leverage. Larkin recommends the Eaton Vance Floating Rate Advantage Fund (EABLX) open-end fund, which yields 6.62 percent, versus the closed-end Eaton Vance Floating Rate Income Trust (EFT), which yields 8.73 percent, as of this writing.

But there's also less volatility.

"If I look at EFT from July 9 to Aug. 15, right before the credit crisis, it dropped 19.2 percent, while EABLX fell only 4.3 percent for that same time period," says Larkin.

Beware expense ratios
Morningstar, which doesn't track true closed-end bank loan funds, reports that the average expense ratio for open-end and continuously offered closed-end funds is 1.39 percent, which is quite pricey. Many of the open-end funds are currently showing yields of 6.5 percent or better, with yields for the continuously offered closed-end funds typically one or two percentage points higher. In both categories, the year-to-date performance is considerably less.

If you can withstand the downdrafts, you'll have to decide if fees and loads are offset sufficiently by the returns to make these a worthwhile investment for your portfolio.

This list isn't meant to be a recommendation to buy; it is a sampling of the open-end and continuously offered closed-end funds tracked by Morningstar and some closed-end funds that can be found on the exchanges. Most of the companies represented offer multiple share classes.

A sampling of floating rate funds

Open-end funds:
AIM Floating Rate (AFRAX).
Eaton Vance Floating Rate (EVBLX).
Fidelity Advisor Floating Rate High Income (FFRAX).
Franklin Floating Rate Daily Access (FAFRX).
Hartford Floating Rate (HFLAX).
MainStay Floating Rate (MXFAX).
MFS Floating Rate High Income (FRHAX).
Putnam Floating Rate Income (PFLRX).
RiverSource Floating Rate (RFRAX).
Security Income Opportunity (SIOAX).
Van Kampen Senior Loan (VSLAX).

Continuously offered closed-end funds:
BlackRock Senior Floating Rate (XMPFX).
Highland Floating Rate (XLFAX).
ING Senior Income (XSIAX).
Oppenheimer Senior Floating Rate (XOSAX).
SunAmerica Senior Floating Rate (XNASX).

Closed-end funds:
BlackRock Floating Rate Income Strategies (FRA).
Eaton Vance Senior Floating Rate (EFR).
First Trust/Four Corners Senior Floating Rate Income (FCM).
Nuveen Floating Rate Income (JFR).
PIMCO Floating Rate Income (PFL).
PIMCO Floating Rate Strategy (PFN).
Van Kampen Senior Income Trust (VVR).
Western Asset Emerging Markets Floating Rate (EFL).