Higher rates on newly issued bonds make the lower yields on older bonds in their portfolios less attractive, and the price of those bonds declines. Many investors are worried about interest rates because the yield on the 10-year Treasury note has been rising. It hit 2.35 percent Wednesday, its highest level in 15 months.
But not all bond funds are equally vulnerable. There is an exception: mutual funds that hold floating-rate debt. They invest in corporate bank loans whose interest rates reset every few months, as well as other kinds of debt whose interest rates fluctuate. That means when rates rise, so can the interest payments of floating-rate funds. Their popularity is booming today on hopes for protection from rising rates, which many investors see as inevitable.
Consider that in 1994, after the Federal Reserve unexpectedly hiked short-term rates six times in 10 months, bank-loan mutual funds returned an average of 6.6 percent, according to Morningstar. The broad U.S. bond market lost 2.9 percent that year.
Investors poured $24.6 billion into bank-loan funds during the first five months of 2013, according to Morningstar. Funds in the category now have a total of $99 billion in assets, a 36 percent surge from the $73 billion that they held at the end of 2012. The flood of dollars is coming when investors are leaving other kinds of bond mutual funds: Investors yanked $2.
Although floating-rate funds can lessen one type of risk -- that of rising interest rates -- investors should remember that they carry others.
"It's not a turbo-charged money-market fund," says Jeff Bakalar, co-head of the ING senior loan group." You can lose money." His ING Senior Income fund returned 14.3 percent over the last 12 months, putting it in the top 4 percent of the bank-loan fund category.
The key risk stems from the kind of companies whose bank loans the funds buy. Many have weak credit ratings, which raises the risk of default. To be sure, bank-loan investors generally recoup more than junk bond holders in cases of default. Junk bonds are debt issued by companies with poor credit ratings.
It also can be difficult for funds to buy and sell the loans when investors are panicked. That's what happened during the financial crisis, says Sarah Bush, senior mutual-fund analyst at Morningstar. Bank-loan funds lost an average of 29.7 percent in 2008.
"You need to be willing to take a little bit of volatility" to invest in bank-loan mutual funds, Bush says, adding that investors should be able to accept a 5 percent loss in a month.
The group's performance had a sharp rebound in 2009, when bank-loan funds returned an average of 41.8 percent in 2009. Fund managers acknowledge that investors shouldn't expect returns like that again anytime soon, but they say the category still looks attractive given the prospect of rising rates.
Expectations for continued improvement in the economy mean the Federal Reserve may trim its bond-purchasing program later this year and halt it by the middle of 2014, Chairman Ben Bernanke said on Wednesday. Investors see that as a first step toward a hike in short-term interest rates, which could happen by late 2014 or early 2015.
A stronger economy would also help floating-rate mutual funds because it would mean a lower risk of defaults.
Here are some additional considerations for mutual-fund investors:
— RETURN EXPECTATIONS
The popularity of floating-rate funds in recent months means that future returns will likely come primarily from the yield that bank loans offer. There's little room left for prices to rise. The average yield for bank-loan mutual funds is 3.6 percent, according to Morningstar.
David Hillmeyer, portfolio manager of the Delaware Diversified Floating Rate fund, says investors could expect an annual return in the low single digits. He invests in higher-quality bonds, which carry lower yields but should have less risk of default. His fund owns floating-rate debt issued by Apple and other big companies.
— WHAT RATE TO WATCH
Interest rates on bank loans rise and fall with a benchmark rate, typically the London interbank offered rate, known as Libor. The one-month Libor rate has been falling over the last year, to 0.19 percent from 0.25 percent.
— THE DELAYED EFFECT
If Libor rates start rising, don't expect an immediate increase to the monthly distributions sent out by bank-loan mutual funds. Libor rates are so low that they're below the minimum interest rates that have been set for many bank loans.
— HIGHER COSTS
With the risk of defaults for bank loans, mutual funds hire teams of professionals to wade through reams of loan documents. That contributes to higher fees. The average bank-loan fund has an expense ratio of 1.19 percent. That means $119 of every $10,000 invested in the fund goes to covering salaries for fund managers and other annual expenses. The average taxable bond mutual fund has an expense ratio of 1 percent, meaning $100 of every $10,000 invested goes toward fees.