Expect more mutual funds aiming to offset rising rates

BOSTON (AP) -- Investors looking for a decent income stream face slim pickings. The appeal of bond mutual funds is fading because an accelerating economic recovery is likely to trigger higher interest rates down the road. Plus there's the possibility of inflation if the economy really heats up. Both threaten to cut into returns for many types of bonds. As for Treasurys, yields slipped last week to their lowest levels of the year. Investors sought the safety of government bonds as fears rose over the nuclear crisis in Japan. And with money-market mutual funds and savings accounts yielding near zero, investor appetites for income "remain insatiable," says Avi Nachmany, research director with fund industry consultant Strategic Insight. It's helped fuel the growth of a niche category: floating-rate mutual funds. These funds invest in the variable interest rate loans that banks make to companies. They're called floating-rate loans because the interest paid on the loans will go up or down periodically to reflect the current market. Those loans can carry higher default risks than bond alternatives offering similar yields, such as many types of corporate bonds. But that negative is offset by the chief appeal of floating-rate mutual funds: The income investors receive adjusts with changes in the interest rate that banks charge on the loans. That feature is enticing, given the reality that near-zero short-term interest rates have nowhere to go but up. Investors are diving head-first into the floating-rate pool, depositing a net $12 billion into these funds in the first two months of this year, according to Strategic Insight. That's huge, considering that these funds hold just $69 billion in assets. The money taken in this year is already two-thirds of the total for all of last year. Fund companies are rushing in as well. Since Dec. 1, they've filed papers with regulators to launch 12 floating-rate funds. Fifty-four are now available. They've been performing respectably lately. Floating-rate funds -- also known as bank loan funds -- have averaged a year-to-date return of 1.8 percent. Still, few investors understand how these funds work. And it makes sense to ask whether any recently hot investment offers decent prospects. Larry Swedroe, research director at the financial advisory firm Buckingham Asset Management, says the scenario often plays out when bond investors stretch for yield. "Every time interest rates are low, investors begin to make bad mistakes -- things they wouldn't do if rates were at 4 or 5 percent," says Swedroe. "This is not an exception." Here's a primer on floating-rate funds, including their potential rewards and risks: --What they invest in: Although floating rates are usually categorized as bond funds, they don't technically buy bonds. Instead, they buy stakes in short-term loans that banks make to companies -- it's a $1 trillion market that's invisible to most individual investors. Often, those companies borrow from large banks because they've got credit troubles that prevent them from easily or affordably raising cash by publicly issuing stock or debt. Some borrowers take out bank loans to fund a leveraged buyout of another company. --How their rates adjust: First, it's important to understand the differences between floating-rate securities and bonds whose rates don't change after they're issued. If interest rates rise, prices for bonds with locked-in rates fall, because investors will be able to buy newly-issued bonds paying higher interest. With floating-rate securities, the rates reset up or down at regular intervals, such as every 30 or 60 days. They adjust in tandem with changes in a market interest rate, such as the London interbank offered rate. Best known as Libor, it's the rate at which banks lend to one another. Higher rates translate into higher yield for fund investors. So investing in floating-rate fund can help offset the bond losses an investor suffers when rates climb. Of course, it's the other way around if you're in a floating-rate fund when rates fall. Declining rates make the funds less attractive, so prices drop, cutting into returns. --Credit risk: The protection from rate increases comes with a downside. There's a higher credit risk than bonds offering comparable yields to floating-rate securities. In case of a default, bank loans are typically secured by a borrower's assets. That doesn't offer guaranteed protection from a loss, but that prospect is reduced compared with investors in unsecured loans, and with high-yield bonds. --Liquidity risk: Bank loans aren't traded on exchanges, so buying and selling is more limited than with stocks or bonds. During credit crunches like the one in 2008, willing buyers for bank loan debt, especially loans made to the riskiest borrowers, can be hard to find. That will send prices down, cutting into the fund's returns. Floating-rate funds averaged losses of 30 percent in 2008. Still, they've managed to come back: The 3-year average annualized return is 5.2 percent, according to Morningstar. --Yields: Floating-rate fund yields currently range from 3 percent to 5.5 percent, depending on the credit risks a fund takes on. "You're getting a pretty attractive yield, with the expectation that your yields will rise along with increases in short-term rates," says Jeff Bakalar, co-manager of the ING Floating Rate Fund (IFRAX). "It's just a matter of time when they do." The funds' current yields looks good compared with those for many other types of debt. For example, 10-year Treasurys now yield about 3.2 percent. And floating-rate funds aren't burdened by the risks a 10-year T-bill investor faces from rising interest rates. But remember: The corporate borrowers that floating-rate investors rely on to pay principal and interest aren't as creditworthy as Uncle Sam, no matter how shaky government finances seem these days. -------------- Questions? E-mail investorinsight@ap.org. Published: Tue, Mar 22, 2011