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The market has been showering profits on investors, raising the question: Where to put this money?
Even when the market's gyrating, I'm content to let the bulk of my money continue to reside in long-term funds that own foreign and domestic stocks, as well as some income securities. But sharp, sudden gains raise the odds of sharp, sudden pullbacks, so I've taken some profits recently and need a home for them.
Money markets are paying good returns these days, approaching 5%, but I'd like to do a little better. So I've been shopping for a bank-loan fund.
The reason is simple: High-quality bonds are yielding less than 5%, while bank loans are delivering 7% and more. "Right now, you're being better compensated to be in loans than other debt instruments," says Kingman Penniman, president of KDP Investment Advisors of Montpelier, Vt.
KDP does research in junk bonds, and that's what bank loans are a form of. But they have greater security than bonds because they are typically secured by collateral. They also have very short maturities, the interest they pay resetting every quarter, so they have negligible interest-rate risk.
Nearly all of the 25 or so mutual funds that invest in these floating-rate loans come from load-fund families, but I've identified four you can buy without loads. Not surprisingly, these no-loads are also the most economical to own.
In addition to serving as a refuge for cash, bank-loan funds are a good supplement to bonds for income-oriented investors. As measured by price volatility, they have about half the risk of the bond market and one-quarter that of long-term bonds, and right now they're yielding more than either.
More subprime worries?
Companies that don't have the credit strength to borrow in capital markets have to go to banks, where they pay interest that starts at 1.5 percentage points above Libor, the London Interbank Offered Rate, the most widely followed rate benchmark in the world. Last week, Libor was about 5.35%.Despite their junk-bond credit ratings, these companies can borrow because they pledge collateral. Bank loans are also senior debt, with the first claim on assets in a default.
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Recently Barron's magazine likened bank loans to mortgages -- of the subprime sort. And certainly risk is increasing in the bank-loan market. Nearly a third of new loan issuance involves lax credit standards, compared with 5% last year, according to KDP.
Fortunately, the looser the deal, the higher the yield, meaning hedge funds and other speculators are the chief purchasers. These loans can carry coupons higher than 4.5 points over Libor, or nearly 10% currently. The mutual funds I've identified yield much less. All come from companies with excellent credit and junk-bond research departments.
| Fund | Expense ratio | 1 year | 3 year | 5 year |
|---|---|---|---|---|
STI Classic Seix Float High Inc I (SAMBX) | 0.55% | 8.66% | n/a | n/a |
Fidelity Adv Float Rate High Inc (FFRHX) | 0.71% | 7.16% | 5.55% | n/a |
Eaton Vance Float Rate Adv (EABLX) | 1.01% | 6.86% | 5.29% | 4.59% |
Eaton Vance Float Rate High Inc Adv (EAFHX) | 1.05% | 7.42% | 5.96% | 5.56% |
Notes: Available without loads from Schwab; the Eaton Vance portfolios also come without transaction fees, as does the Fidelity fund if purchased directly from Fidelity. EAFHX, EABLX have no transaction fees. Performance as of 5/29/07. n/a: Not available; fund too new.
Sources: MSN Money, Charles Schwab & Co., Morningstar Inc.
STI Classic Seix Floating Rate High Income Fund (SAMBX) is managed by Seix Advisors, a specialist in junk-bond investing. Manager George Goudelias says he has been combating lax lending standards by stressing asset-rich sectors like health care, telecommunications and utility companies. He's playing down service and distribution industries, where assets are less secure.
Note: When I called STI, its spokesman was surprised I could buy this fund from Schwab; it is intended for institutional investors. (The Schwab minimum is $1,000.) He said the fund's directors would have to review whether it should continue to be available this way, a process he said would take several weeks. Meanwhile, it remains available.
Fidelity Advisors Floating Rate High Income (FFRHX) is a Morningstar Analyst Pick, signifying that research firm's confidence. Manager Christine McConnell is "among the category's more careful bosses when it comes to credit risk," Morningstar's Paul Herbert wrote in a report in May.
Herbert also notes that Fidelity recently cut the expense ratio of this fund to 0.71%, one of the lowest in a category that tends to have high expenses. The average is 1.44%.
Eaton Vance Floating Rate Fund (EABLX) differs from its companion, Eaton Vance Floating Rate & High Income Fund (EAFHX), in that the latter also puts about 10% of assets into junk bonds, which have higher yields than bank loans.
Last year, as interest rates rose slightly, the typical mutual fund investing in long-term government bonds -- supposedly the safest kind -- eked out a total return of only 0.15%. Intermediate-term bond funds rose 4.14%. Bank-loan funds were ahead an average of 6.57%.
If interest rates begin to tick down -- and the market rallied last week on growing confidence that they will -- bank-loan funds will lose some of their edge because interest rates on quarterly loan resets will be lower rather than higher. But with rates closer to historic lows than highs, they can't go a lot lower.
Also, Libor is sensitive to rates overseas, which have continued rising as the Federal Reserve has paused.
My pick among these four funds is STI Classic, owing to its rock-bottom expense ratio.
In accord with MSN Money policy, I won't buy it until at least three days after this article appears.
Fidelity customers are well served with its fund. The Eaton Vance funds, despite their higher expenses, don't involve transaction fees at Schwab, so they are cheapest if you plan to own the fund for only a year or so.
At the time of publication, Tim Middleton didn't own any securities mentioned in this article.
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