Where bond investors find a haven from rising rates

How do you preserve capital when the bond market heads south?

It's a perplexing issue for many bond-fund investors, who saw their fixed-income holdings unexpectedly shrink in value during this year's second quarter. As long-term interest rates rose, bond prices fell and most types of bond funds had negative returns of 1 to 2 percent. Many economists expect sluggish economic conditions in the United States to improve in the second half of the year despite the drag of a weak housing sector. That's likely to keep upward pressure on interest rates, even if Federal Reserve policymakers hold the benchmark federal funds rate steady at 5.25 percent, analysts say.

While an upswing in rates is generally bad news for bond funds, one specialized slice of the bond-fund universe, bank-loan funds, has little to fear from an advance in rates. That's because these funds benefit from the floating-rate nature of the assets they hold. So far this year, according to Morningstar, bank-loan funds have returned 2.5 percent, outpacing all but one type of taxable bonds fund (emerging markets). Over the past three years, the average bank-loan fund has returned 5.2 percent annually compared with 3.4 percent for the average taxable-bond fund.

The funds, also called "loan participation" funds, buy pieces of adjustable-rate loans that banks make to corporate borrowers with less than investment-grade credit ratings. The rates are typically reset every two to three months based on an interbank lending benchmark that has been edging up lately.

If interest rates rise, bank-loan funds are a "more prudent choice than most bond funds because of their low volatility," says Scott Page, comanager of the Eaton Vance Floating Rate fund. Bond prices move inversely to interest-rate changes, but the net asset values of bank-loan funds should be more stable than most bond funds, he says.

"The reset feature is what makes the funds attractive in a rising-rate scenario, because it protects your principal," agrees Paul Herbert, an analyst at Morningstar.

Dividend payouts on bank-loan funds range from 6.25 to 8 percent. Those with the highest payouts, he says, typically plow a portion of their assets into dicier junk bonds and use borrowed money as leverage to enhance yields.

Another positive attribute is that bank loans are secured by collateral and classified as "senior" debt. That gives lenders first call on a borrower's assets in case of default. By contrast, high-yielding junk bonds are generally unsecured or subordinated debt.

As an asset class, the funds show low correlation with bond or stock price movements. That makes them an "effective diversification tool" for fixed-income investors who own different kinds of securities, says Chris Neubert, president of Moneco, an asset-management firm in Southport, Conn. "They can offset some of the interest-rate risk in a bond-heavy portfolio."

The funds have a good track record with respect to controlling volatility, Mr. Herbert adds, but they are not as safe as money-market funds or CDs.

Nor are bank-loan funds true alternatives to CDs or money-market funds, advisers say. If the credit environment were to deteriorate and loan defaults climb, bank-fund values would also decline sharply as they did during the last recession, notes William Larkin, fixed-income manager at Cabot Money Management in Salem, Mass.

Moreover, interest-rate spreads between Treasury bond yields and lower-rated debt, which have been very tight until recently may well widen. "If subprime mortgage debt problems spill over into the bank-loan market, where loans trade in a secondary market, there may be liquidity problems," Mr. Larkin says.

Before selecting a bank-loan fund, investors need to do their homework. Check out fund prospectuses and the most recent shareholder reports. Riskier bank-loan funds use leverage to spice payouts, and that adds to volatility. Funds with payouts above 7 percent deserve close scrutiny, says Herbert. "At this stage of the credit cycle, you want to be more cautious," he says.

Two of Morningstar's favorites are Fidelity Floating Rate High Income Fund, one of the few no-load funds in the group, and Eaton Vance Floating Rate Fund. Both focus on higher-quality loans, possess seasoned credit-research teams, and boast modest expense ratios.