Short-duration funds ease rate fears

Rising interest rates don’t have to spell pain for fixed-income investors if their money is in mutual funds that invest in floating rate notes.

Floating rate funds, also known as loan participation funds, prime rate funds or senior secured bank loan funds, invest in a basket of loans that banks or bank syndicates make to corporations.

Retail investors have pumped $37 billion into this niche bond sector with another $156.4 billion being invested by institutions, according to New York investment house Donaldson Lufkin & Jenrette Inc.

With more rate hikes looming, “The asset class has never been more noteworthy,” says Jeffrey Maillet, executive managing director of the senior loan asset management department at John Nuveen Co. in Chicago. “There’s not a better asset class that a potential investor can be in in a volatile market.”

Perhaps the biggest benefit of floating rate notes is that unlike bonds, their returns move in tandem with interest rates.

The rates of return on these bank loans float, meaning they are fixed only for a period usually between 34 and 46 days, then are reset.

volatility insulation

“In effect you have a zero duration,” says Brian Good, who runs the $76 million Stein Roe Advisor Floating Rate Fund. “That insulates a portfolio from a whole lot of volatility.”

As interest rates rise, the mutual funds buying these loans aren’t left holding notes paying below-market rates, says Mr. Maillet, a former banker generally regarded as the father of this type of fund.

Because the individual loan rates are reset periodically, these funds typically maintain steady net asset values, another plus for risk-conscious investors, says Mr. Maillet.

Of course, because of their short durations, these funds are hurt when rates go down. That might explain why the average five-year return for floating rate funds was 7.01% at yearend — to 7.36% for the average long-term Treasury fund. All Treasury funds, however, averaged 6.54% during that period.

One risk is default, but since these bonds are collateralized with a company’s hard assets, the risk is minimal. Moreover they are senior loans, they are the first to be paid back.

Floating rate funds can provide an alternative to low-yielding government bonds, but they’re also appealing as the government buys back its debt, says Michael Ling, president of Berkeley Inc., a financial adviser in Boise, Idaho.

“This provides a way to increase the yield with an exceptional return,” says Mr. Ling.

The largest funds include the $7.4 billion Van Kampen Prime Rate Income Fund, the $4.7 billion Eaton Vance Classic Senior Floating Rate fund and the $4.1 billion Eaton Vance Prime Rate Reserves fund.

A few fund companies and brokerages such as Eaton Vance Corp., Van Kampen Funds, Merrill Lynch & Co. Inc. and Morgan Stanley Dean Witter & Co. have bank loan funds that date back to the late 1980s when the securitization of bank loans came into vogue and was first recognized as an asset class in its own right. In recent years other fund companies, such as Aim Management Group Inc., Nuveen and Franklin Resources Inc. have introduced bank loan funds of their own.