2005-05-26 / Business & Finance

Mutual Funds Offer Opportunities

One of the “laws” of finance is the relationship between bonds and interest rates. When interest rate go down, the price of bonds goes up. Why is that, you may ask? Well, let’s say that I bought a 30-year Treasury bond two years ago and it had a coupon of 8%. Now, you want to buy a 30-year Trea-sury bond assuming that new issues are only paying 6%. You, or someone else in the secondary market, will pay me a lot more than I paid for the bond because my bond is still relatively new - it has 28 years left and it pays 2% more than does a new model.

Falling interest rates have pretty much been the story since 1982 until a few months back when the Federal Reserve, for the first time in a long time, raised the Fed Funds rate, which was the signal that rates had bottomed out. Well, what happens to the price of bonds when interest rates go up?

Come on, you know, the price of bonds goes down. It’s just the reverse of the above. Say I bought a 30-year bond two years ago with 6% coupon, and now you want to buy a 30-year bond and current coupons are at 8%. You, or someone else in the secondary market, will pay me a lot less than I paid for the bond because my bond is still relatively new - it has 28 years left and it pays 2% less than does the new model.

Does this mean that I shouldn’t buy bonds? Not really, because a well-diversified investment portfolio should contain some stocks, some bonds, and some cash. But there are bonds and then there are bonds. This column is about something that is “bond like.”

There are mutual funds that buy loans from bonds. They are called senior-secured, floating-rate, or prime rate funds. These funds buy floating rate loans made banks to companies whose credit ratings are, shall we say, “not the greatest.” The banks typically issue these short-term loans at rates above the LIBOR, the London Inter-bank Offered Rate, which acts like an international prime rate.

What makes these commercial loans different are that like adjustable rate mortgages for homeowners, they adjust periodically (typically every 60 to 90 days) as the LIBOR rate changes. So, during a rising interest-rate environment, the yield climbs providing inves-tors with more money. At the same time, the underlying price of the mutual fund holding these loans usually remains stable, unlike the price for regular bonds or bond mutual funds, which normally fall when rates rise.

Back to the credit side of the loans: adjustable rate bank loans are pledged against specific collateral. This means if the borrower does not make payment on a timely basis, the lender can seize certain goods.

Additionally, in the event of bankruptcy, the “senior secured” loan has priority over the company’s stock and bond claims.

Another benefit of these floating-rate funds is that they can provide diversification in an investment portfolio. They are not strongly correlated with most types of fixed-income in-vestments including U.S. Treasuries, investment-grade corporate bond funds averaged over 10%. Through June of 2004, just as the Fed began raising short-term interest rates, bank loan funds were up nearly 2%, ahead of all other bond categories.

Are these funds for windows and orphans? No. Should they have a large position in a portfolio? No. Should they have a 5-10% position in a portfolio? Maybe.

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