A Great Diversifier for Your Bond-Fund Money

Interested in a fixed-income investment that will increase in value when interest rates rise, as they inevitably will? Then you should get to know senior floating-rate bank-loan funds.

These funds won't make you rich — except in the unlikely event that interest rates soar, as they did in the 1970s. But they're a lot safer, in several respects, than other high-yielding "junk" bonds, a category to which they're closely related, and I think they make a good diversifier for some of your bond money.

Two no-load funds stand out in this category. Pimco Senior Floating Rate D (symbol PSRDX) launched in 2011, but manager Beth MacLean has more than 25 years of experience investing in bank loans. Christine McConnell has successfully steered Fidelity Floating Rate High Income (FFRHX) since its inception in 2000.

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The Pimco fund's 30-day SEC yield is 3.0%, and the Fidelity fund's is 2.7%. Pimco says the SEC yield understates the fund's annual cash payout by roughly one-half of one percentage point. Presumably, that would also be the case with the Fidelity fund.

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Banks have been lending money to businesses for as long as banks have existed. But investors, such as mutual funds, only became interested in these loans in the 1990s. The market in senior floating-rate bank loans has grown to about $620 billion.

All of these bank loans are below investment quality. "Think of senior loans as a very close relative of high-yield bonds," MacLean says.

But bank loans differ from junk bonds in several ways. Most important, their yields reset every 30 to 90 days at a premium to Libor (the controversial short-term rate officially known as the London Interbank Offered Rate). The Libor rate is typically not much different than the yield on short-term Treasury bills, which are now essentially zero. If Libor yields rise, so do the yields on the loans; if rates fall, the yields fall. However, most loans have a "floor" limiting how low their yields can drop.

As is the case with junk-bond issuers, borrowers in the senior-loan market face a real risk of being unable to make their payments. The advantage of owning senior loans is that such creditors stand at the front of the line in the event of a bankruptcy. Consequently, borrowers involved in bankruptcy reorganizations eventually pay 70% to 80% of what they owe on their senior loans. That compares with a recovery rate of 20% to 40% from bankrupt issuers of ordinary junk bonds.

The Pimco fund has yet to experience its first default, and MacLean expects the default rate to remain low over the next year or two. At the same time, however, the upside of bank loans is limited. The loans are usually callable at par (face value) or a little more. And in any event, the average maturity of loans in the Pimco fund is just 3.5 years. So don't expect much in the way of price gains in these funds, says MacLean. "We expect more of a coupon-clipping type of return," she says.

What can really hurt these funds is a deep recession. In 2008, during the financial crisis, the average bank-loan fund plunged 29.4%. The funds bounced back in 2009, gaining an average of 43.1%, but a lot of investors sold out before the rebound. Both the Fidelity and Pimco funds are more conservative than most bank-loan funds. In 2008, the Fidelity fund lost only 16.5%.

Even the fear of a downturn can hurt these funds. In August 2011, when Standard & Poor's downgraded U.S. government debt and markets tanked, the average bank-loan fund fell 4.4% that month. The Pimco fund lost 3.6% and the Fidelity fund dropped 3.3%. The lesson is clear: "These are not money market funds," says Morningstar analyst Sarah Bush.

Which fund to buy? I'd stick with the Fidelity fund unless you can qualify for the institutional share class of the Pimco fund. Annual expenses for the Fidelity are 0.71%, compared with 1.10% for the Pimco Class D shares. The Pimco institutional shares charge 0.80%, but the minimum investment is generally $1 million.

Steve Goldberg is an investment adviser in the Washington, D.C., area.