This Fund Banks on Bank Loans

For income seekers, rising interest rates often mean trouble. That’s because prices of bonds usually fall when rates climb. One way to defend against rising rates is to invest in floating-rate loans. Rates on these loans, which banks make to businesses, are pegged to short-term benchmarks and typically reset every 30 to 90 days. That means that when rates rise, the interest you receive on these IOUs, also called “leveraged loans,” goes up as well.

Because many investors expect rates to rise, they have been pouring money into bank loans. But these investments come with another kind of risk. Firms that take out floating-rate loans typically carry sub-investment-grade credit ratings and are more likely to default than less-indebted, higher-quality firms.

For most people, the best way to invest in bank loans is through a mutual fund, such as Eaton Vance Floating-Rate Advantage (symbol EAFAX), that avoids loans to high-risk borrowers. Managers Scott Page and Craig Russ, along with a team of 29 researchers, start by weeding out the smallest borrowers as well as companies that have too much debt. The team favors loans issued to established companies with ample earnings and assets to cover their debts. To be considered for inclusion in the portfolio, a loan must be “senior secured,” meaning that in the case of a default, holders of the loan have first dibs on the company’s assets—even before bondholders.

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Nearly all of the fund’s holdings carry below-investment-grade ratings, but the managers skew toward better-quality junk. At last report, the fund had 86% of its assets in double-B and single-B-rated loans (the highest junk ratings), compared with 69% for the average bank-loan mutual fund. Those loans the managers deem the least risky occupy the largest positions in the portfolio, but no loan commands more than 1% of assets. The strategy, the managers say, is to win more by losing less.

Of course, they are still trying to win. To juice up the fund’s yield, the managers borrow the equivalent of 20% to 30% of its assets and use the proceeds to invest in additional bank loans. The fund’s Class A shares currently yield an above-average 4.2%. They come with a 2.25% sales charge, but are available without a load or transaction fee at several online brokers.