With the Fed funds rate closing in on its third birthday pegged at the rock-bottom low of zero to 0.25%, it's not hard to figure out which way rates are headed. "There's no place to go but up," says Diane Pearson, an advisor with Legend Financial in Pittsburgh.

When interest rates rise and bond prices fall, will the long bull market in bonds come to an end, or at least pause? Probably. But that doesn't mean fixed-income investors must suffer. That's where bank loan funds come in. They have the potential not only to withstand rising rates, but also to benefit from them. Many investors are getting the message, increasingly turning to them to hedge against higher rates. In fact, investors poured $23 billion into the funds in the first five months of the year, according to Lipper.

Bank loan funds, also called floating-rate bond funds, invest in debt made by banks to companies for terms of 40 to 50 days. The loans are securitized and sold to investors. They usually offer coupons based on the London Interbank Offered Rate, plus a few percentage points. Because the loans reset quickly, they carry little interest rate risk. If rates were to rise, the coupons would too. Longer-dated bonds, on the other hand, suffer price declines when rates rise.

For this reason, bank loan funds are well-positioned for the upcoming environment, says Craig Russ, co-manager of the $8.8 billion Eaton Vance Floating-Rate Fund. It's a favorite among advisors like Pearson because of its measured approach to the sector. Unlike others, it does not use leverage to try to pump up returns. Russ and co-manager Scott Page maintain a highly diversified portfolio of almost 500 names.

For the three-year period ended July 1, the fund is up 5% a year annualized, in the bank loan category's top 38% as tracked by Morningstar. Over the five-year period, the fund gained 3.7% a year annualized, in the category's top 36%. The fund is a Morningstar analyst pick.


While Russ understands why investors have clamored for bank loan funds to hedge against rising rates, he worries recent history has given investors a skewed view of the asset class. In late 2007 and 2008, bank loans suffered severe losses, along with other high-yield categories, as investors turned exceedingly risk averse after years of clamoring for higher returns. Highly levered investors dumped their bank loans just as a wave of new supply hit the market.

In all, the average fund in the category suffered a 29.7% drop in 2008, according to Morningstar. Eaton Vance Floating-Rate Fund was no different, down 30.4%. Since then, the fund has rebounded sharply along with the fortunes of other high-yield bonds. In 2009 and 2010, the average fund in the category soared 46.2% and 9.2%, respectively, from price appreciation.

That's not likely to happen again. "Bank loan funds are supposed to be boring," Russ insists. "The moves in 2009 and 2010 aren't sustainable."

Russ and Page believe that investors may be setting themselves up for unrealistic expectations as bank loan funds return to their normal pattern. "In its basic nature, this asset class generates an income of LIBOR plus 4%," Russ says.

As the experience of 2008 illustrates, bank loans do carry risks. Despite their short terms, loans can default. After all, these are below investment-grade companies adding on debt. During the financial crisis, the default rate reached 11%, although it's fallen precipitously to about 1%. The improving credit quality of many issuers has attracted investors too.

On the flip side, recovery rates are much higher than for high-yield bonds, running about 70 cents on the dollar vs. 30 cents. The reason? Bank loans are highest on a company's capital structure, which is where their other name, senior and secured debt, comes from. The loans are secured by collateral, like bonds or equity. "A lot of value needs to be destroyed before that floating-rate piece gets hurt," Russ explains.

Russ and Page look for deals where bank loans make up less than 40% of a company's outstanding capital. That way, there's lots of unsecured bonds and equity as collateral in case of default. Another risk is that the bonds are callable, meaning a borrower can pay off the balance at any time. There's always the possibility of participating in a refinancing, but the terms may not be as favorable.


Due to these risks, Russ and Page believe in keeping a broad portfolio. "Just in case we get it wrong, one name won't take the portfolio down," Russ says. He looks for companies with a competitive advantage and a strong balance sheet. Less important is determining a company's potential for earnings growth.

"Bank loans are actually the simplest part of that capital structure," Russ says. "We are lending money at 100 cents on the dollar. We want a loan that pays us interest and then pays us back 100 cents on the dollar. That's it."

Russ, a former bank loan analyst, is most concerned with how much cushion there is down the capital structure supporting the loans. "We are looking at how valuable and how stable this business will be if we get into a recession," he explains. That analysis leads him and Page to favor bigger companies. They have more financing options, something that could prove important if the economy slumps into another recession.

A favorite holding is Community Health Systems, operator of 120 hospitals in 29 states, mostly in rural communities. The bonds, rated Ba3 by Moody's and BB by Standard & Poor's, originally entered the floating-rate market when private equity group Forstmann Little acquired the firm in 1996. It went public in 2000. In recent years, Community Health used its bank loans to finance deals and more than doubled in size.

"Hospitals are generally very stable," Russ says. "In rural areas, it might be the only hospital within 90 miles, and we like barriers for competitors." The loans pay a coupon of LIBOR plus 3.5%.

Another top holding is Burger King, which was taken private last September by a Brazilian equity group, 3G Partners. At that point, the firm sought financing from the bank loan market. Russ believes the company is on the right path.

"Burger King has gone through periods of not performing well," he says, "but this management team has done a lot to freshen up the stores and add healthier items to the menus." The loan was issued at LIBOR plus 5% but, at the beginning of the year, Burger King refinanced to LIBOR plus 3%, with a 1.5% LIBOR floor.

Perhaps the holding that best demonstrates how Russ seeks to protect his fund's interests is Rite Aid. Rated CCC by both S&P and Moody's, Rite Aid carries the lowest rating in the portfolio. Usually, the fund eschews retailers because shoppers can be fickle.

But the Rite Aid loan - which carries a coupon of LIBOR plus 3.25%, with a 1.25% LIBOR floor - has some added protection. The securities are known as asset-backed loans because they are backed by a percentage of prescription sales. "The ABL is a safe way to loan money to retail businesses," Russ says. "Those prescriptions are an asset, like collateral."

Ilana Polyak, a New York financial writer, contributes regularly to Financial Planning.