When interest rates rise, fixed income investments, like bonds, decrease in value, or so the theory goes. However, rising interest rates do not always mean losses for all fixed income investments. Bank loan funds, also known as prime rate funds, are an exception to the rule. In fact, they can even be labeled as alternative fixed income investments.

A bank loan mutual fund invests in senior-secured floating-rate bank loans that are based on Prime Rate or Libor (also known as the London Interbank Offer Rate - a kind of international prime rate). The rate the borrower usually pays is typically a few percent more than the Prime Rate or Libor. The loans are created when banks lend money to corporations to purchase large amounts of equipment or to build new facilities. Many banks sell the loans, mainly to mutual funds and other institutional investors, while others hold them in their own accounts.

Interest-rate fluctuations are another reason to consider bank loan funds. Bank loans don’t increase or decrease in value inversely to movements in interest rates in a significant manner, as bonds do. This is due to bank loan interest rates resetting themselves within 60 to 90 days after interest rates change. However, when interest rates are increasing, the loans will slightly increase in value (the opposite of bonds), and vice versa; therefore, it is possible to increase or decrease in value.

Bank loan funds have little or no correlation with any asset class and can be a good hedge against declining stock prices and inflation. However, the credit and liquidity risk on these vehicles are a consideration that should not be overlooked.

One risk is that banks may lend to companies who are poor credit risks. This means the borrowing companies could default on the loan, which could eventually become worthless. In addition, most of these loans are not monitored by credit agencies since the lending banks provide the credit analysis. This risk is somewhat mitigated by the fact that most bank loan funds only buy senior-secured loans, meaning in the event of a liquidation, they are pledged against the physical assets that were purchased or constructed, which should provide ample protection in most situations. Furthermore, bank loans purchased by bank loan funds have a very good history with very few defaults occurring, to date.

Also, credit risk is significantly reduced with the knowledge that the secured assets can be sold to pay off the loan. Bank loans are higher in a company’s capital structure than are bonds, so they will be paid-off first. In fact, when loans have defaulted, frequently the fund receives stock of the defaulting company, which often rises in value when the company comes out of bankruptcy thereby allowing the fund to receive a greater principal value than the loan itself. However, this type of event is not a panacea. Many companies do not come out of bankruptcy and it may take a few years for the fund to receive its money from the pledged assets when they are liquidated. Another added safeguard is the fact that portfolio managers of bank loan funds perform their own credit analysis of all loans before purchasing them.

The market for bank loans is relatively small. Therefore, these loans are not very liquid. Consequently, access to one’s money is not immediate. Most funds allow redemptions only once per quarter or once per month, depending on the fund. This is actually a positive because investor monies will not be redeemed from the fund all at once.

Another liquidity problem concerns pricing. The Securities and Exchange Commission strongly encourages bank loan funds to utilize outside pricing services. These pricing services estimate the value of each loan on a daily basis. Bond funds frequently use pricing services as well to price infrequently traded bonds such as municipals. The good news is that trading volume has increased on bank loans. This with the utilization of pricing services has made bank loan funds significantly more viable investments and liquid.

Bank loan funds can be considered an alternative Fixed Income Investment since they make money when bonds don’t. As interest rates increase, these funds are an even more valuable part of any portfolio. Unlike many of its fixed-income counterparts, bank loan funds have performed well in 2003 and especially since July when interest rates began to rise. We believe these investments will become significantly more popular in the next few years as interest rates rise.