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Mutual Funds

Eureka! High Income, Low Risk

Bank loans to financially troubled companies pay off for these funds.

These are unsettling times for income investors. Bond and bank-product yields remain extraordinarily low, and recent market turmoil shows that high-dividend stocks and junk bonds can be volatile. If you want high income with low risk, consider making room in your portfolio for a bank-loan fund.

These mutual funds invest in loans banks make to corporations, typically those with shaky finances. Interest rates on these "floating-rate loans" reset every one to three months, with banks charging a premium above a designated short-term-rate benchmark. Because of the adjustment mechanism, prices of the loans usually hold up even when interest rates rise -- one of the biggest risks of holding bonds.

Don't let borrowers' junk ratings turn you off. The top class of floating-rate loans, first-lien loans, has first dibs on a company's assets in a bankruptcy. Such loans have traditionally formed the core of bank-loan-fund holdings. As a group, the funds have outpaced Treasury bills by an average of two percentage points per year over their 19-year history.

There's only one no-load fund in the category and it's a keeper: Fidelity Floating Rate High Income (symbol FFRHX; 800-343-3548). A member of the Kiplinger 25, the fund has been marvelously consistent. In its first four full years, its annual returns have ranged from 4.2% to 6.5%. The fund showed its low-risk colors on February 27, the day markets around the world plunged, by not surrendering one penny of share price.

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The average junk bond lost 0.3% that day. Manager Christine McConnell mostly holds loans made to large companies that could sell assets if their finances deteriorated. "Cable, telecom and energy companies all have underlying assets," says McConnell. "That gives you something to lean on if they run into trouble." During her seven-year tenure, the fund has experienced just two unexpected defaults. The fund currently yields 6.3%.

You can find other good bank-loan investments among closed-end funds. Closed-end funds sell a fixed number of shares, then trade on an exchange just like stocks. Supply and demand determine the share price, so you can sometimes buy closed-ends at a discount to the value of their holdings, or net asset value (NAV). Discounts can narrow or turn into premiums, leading to bonus price appreciation.

Boosting yields

Closed-ends also have an advantage in boosting yield. Unlike open-ends, they don't need to hold cash to meet shareholder redemptions. Plus, they can borrow money to invest in more loans -- a strategy that boosts yield but also increases volatility. Note, too, that some closed-ends invest in higher-risk bank loans to pump up yield, and some even tap into regular junk bonds and emerging-markets debt.

Two funds stand out for their conservatism. LMP Corporate Loan Fund (TLI) recently had 96% of assets in first-lien loans, mostly made to companies rated BB (the highest junk rating). The fund, which is 35% leveraged (meaning it has borrowed money worth 35% of its net assets), gained an annualized 6.6% on assets over the past five years. The shares sold for $13.87 in mid March -- a 4% discount to NAV -- and yielded 7.9%.

The oldest closed-end remains one of the best. Launched in 1988, ING Prime Rate Trust (PPR) recently had 98% of assets in first-lien loans. Co-manager Jeff Bakalar says that finding top-quality loans has been challenging lately. But he believes that a defensive strategy tends to come out ahead over a full economic cycle. The fund, which is 45% leveraged, returned an annualized 7.9% on assets over the past five years. At $7.33, it yields 7.3% and trades at a 4% discount to NAV.