Bank-Loan Funds

During periods when investors are concerned about rising interest rates, demand for bank-loan funds tends to spike. As their name makes clear, these funds invest in bank loans. Banks typically make such loans to companies as part of a leveraged buyout deal, and then they sell these loans to institutional investors and mutual funds. The yields on the loans rise and fall along with interest rates, which helps cushion the effect of interest rate changes on the funds' net asset values.

Watch for credit risk

Though bank-loan funds have limited interest rate-related risk, they can carry substantial credit risk. That's because the loans that populate most bank-loan portfolios have been extended to lower-quality borrowers, some of which are distressed and/or operate in cyclical industries.

Watch the fees

Secondly, most charge relatively high fees when compared with the average bond fund. Further, some use investment leverage, which boosts gains but also magnifies losses. Leverage is essentially borrowing to invest. Say a fund with $100 million in assets invests those assets in a security returning 10% over a given period. In addition, it borrows another $25 million, which it invests in the same security with the same 10% return. At the end of the period, the fund will have increased in value by $12.5 million (10% of $125 million), representing a 12.5% return on the $100 million of its own assets invested by the fund, greater than the 10% the fund would have earned had it not borrowed the $25 million. However, if the securities the fund holds were to fall by 10% instead of rising by 10%, it would be left with a loss of 12.5% rather than the loss of 10% that an unleveraged fund would have endured.

Though bank-loan funds display less sensitivity to interest rate shifts than many bond funds, that doesn't mean they can't lose money. In fact, bank-loan funds were the worst performing fixed-income category in 2008, losing a whopping 29.7%. In addition to concerns about borrowers' ability to repay their loans, bank-loan funds also suffered that year because some owners of the loans, especially hedge funds, were forced by redemptions to unload shares at the height of the market panic.

In sum

When examining bank-loan funds, be sure you understand the funds' credit profile, watch costs, and be sure you know whether or not the fund uses leverage.