INCLINE VILLAGE, Nev. - Three weeks ago I wrote one of my most important columns titled "Profiting from a Rising Rate Environment." This timely article can be found at tahoebonanza.com as well as my ETFportfolios.net blog. Within that article there was a brief mention of an investment called bank loan funds. Here are more details on why this investment is well suited for today's market environment.
Bank loan funds, also called floating rate funds, invests in loans made by banks to corporations, most of which are rated below investment grade. Because the loans "float," their interest rate re-sets on average every few months. The rate is tied to the London Interbank Offered Rate (called LIBOR), which is added to the fixed amount of each loan set at origination. For that reason investors look at bank loan funds and other adjustable-rate securities as short-term vehicles that do not have the interest-rate risk of long-term bonds.
In a rising-rate environment bank loan funds can and will raise their monthly dividends. That, together with their attractive yields today, make them worth a closer look. What are the risks? There are two. First, most of the loans are below investment grade (read "junk bonds"). That means the ability of the borrower to pay is more closely tied to the economy than to the level of interest rates. They would not do well in a recession. Still, because the loans are senior and secured, recovery in the event of a default would be higher than with other loans.
The second risk comes from the use of leverage. The funds use some borrowed money to purchase additional loans. That's fine under normal conditions and enables the funds to pay more to investors, but they suffered during the financial crisis, as did virtually every investment. For that reason, these funds bear watching.
In past articles I've recommended the Eaton Vance Floating Rate Trust (NYSE symbol EFR), which currently yields 6.4 percent. Another option is PowerShares Senior Loan Portfolio (BKLN). It is a safer play and yields 4.8 percent. I like both.
Although rates may remain low for longer than expected, it's comforting to hold some securities that will benefit when rates begin to rise. After all, that day will come. It's not a matter of "if," it's a matter of "when."
- David Vomund is an Incline Village-based fee-only money manager. Information is found at www.ETFportfolios.net or by calling 775-832-8555. Clients hold the positions mentioned in this article. Past performance does not guarantee future results. Consult your financial advisor before purchasing any security.