It's been an interesting year so far forbond investors. With interest rates plummeting and risk-averse investors flocking to fixed-income instruments, some bonds—particularly short-term Treasuries and agencies—have provided solid overall returns despite extremely low yields. In contrast, other areas of the bond market, such as high-yield bonds and mortgage-backed securities, have been decimated.

Unfortunately, this puts many advisors in a tough position. Where can they find decent yields for clients without getting their heads handed to them if, as many expect, the Federal Reserve ratchets up interest rates next year? One option may be floating-rate loans.

Floating-rate loans, also called senior secured or bank loans, are adjustable-rate commercial loans issued by banks to below-investment-grade corporations in need of short-term financing. The borrowers, which include household names like Ford, Goodyear Tire & Rubber and Dole Foods, use the loan proceeds for acquisitions, recapitalizations and stock repurchases.

Floating-rate loans come with a twist, though. The yields on these loans adjust periodically to mirror changes in market interest rates. These changes, which typically occur every 30, 60 or 90 days, are usually pegged to movements in the benchmark LIBOR. This periodic rate adjustment helps floating-rate loans maintain a fairly stable price, even when interest rates rise.

Interest Rate Hedge

"One of the unique characteristics of floating-rate loans is that unlike most fixed-income instruments, they provide a hedge against rising interest rates," notes Scott Page, vice president and head of Eaton Vance's bank loan investment group in Boston. "In fact, during many market environments, floating-rate loans are actually negatively correlated to traditional bonds."

That could prove to be a major selling point for many advisors in a rising interest rate environment. For example, in 1999 the Federal Reserve raised its federal funds rate target three times in five months, triggering a major decline in fixed-income markets. During that year, 30-year Treasury bonds, as measured by the Citigroup 30-year Treasury Index, lost a staggering 14.9%.

Nor was the damage confined only to the long end of the yield curve. The Lehman Brothers Government Bond Index, a broad measure of the Treasury and agency bond markets, fell 2.3% in 1999, only its second losing year in the past decade. In contrast, the Credit Suisse Leveraged Loan Index, which tracks a broad basket of floating-rate instruments, jumped 4.7% that year.

Floating-rate loans have also enjoyed relatively good performance through the first half of this year, despite the turbulent credit markets. In fact, the Credit Suisse Leveraged Loan Index was off only 2.7% through July 31, although many individual floating-rate loan funds have experienced steeper losses, particularly if they employed significant leverage or had heavy exposure to the financial services sector.

These declines may provide investors with an unusual opportunity, notes Robert Dial, portfolio manager of the MainStay Floating Rate Fund. "While floating-rate loans have historically traded at or near par value, many of these instruments are currently trading at significant discounts, which provides an opportunity for capital appreciation we don't generally see in this area."

Page agrees. "Right now everyone is so caught up in the credit crisis they are overlooking a great opportunity in floating-rate instruments. There is so much fear out there right now it's creating a real opportunity for floating-rate loan investors."

Risky Business?

Still, floating-rate loan funds are not for everyone, cautions Perry Piazza, co-chief investment officer at Contango Capital Advisors in Berkeley, Calif. "They can be a wonderful tool in the right situation, but advisors must understand their limitations before adding them to client portfolios," he says.

For example, many floating-rate loan funds use leverage to boost their returns. While this can lead to spectacular gains in the right situation, it can backfire when things go wrong. "In a tough credit environment, loan values often decline, which will negatively impact returns even after factoring in the relatively strong yields associated with these instruments," Piazza warns.

Because floating-rate loans are issued primarily to non-investment- grade corporations, they also come with a higher credit risk. This was a problem in 2001 and 2002, when a weak economy, excessive leverage and a high loan concentration in the imploding telecommunications sector all combined to drive default rates to a peak of 7.61% in 2001, according to Credit Suisse First Boston.

Since then, many funds have tried to insulate their portfolios from excess credit risk by focusing on liquidity and diversification, Page says. "Investors can't completely protect themselves from the credit risks inherent in these instruments, but properly managed and diversified credit risk isn't the defining characteristic of the asset class."