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Floating Rate Loans

AS INVESTORS HAVE sought both higher yields and protection against rising interest rates, some have turned to floating rate funds, also known as bank-loan or leveraged-loan funds. Examples include ETFs such as Highland/iBoxx Senior Loan ETF, Invesco Senior Loan ETF and SPDR Blackstone/GSO Senior Loan ETF, and mutual funds like Fidelity Floating Rate High Income Fund and Pimco Senior Floating Rate Fund. There are also closed-end funds that focus on bank loans, many of which use leverage to goose their yield.

The loans held by these funds have their rates pegged to short-term interest rates. That means you aren’t locked in at current yields, which is the danger faced by those owning regular fixed-rate bonds. But while bank-loan funds may be a good defense against rising interest rates, you could suffer if the economy turns down.

The reason: The loans involved are typically made to companies that are rated below investment grade. Because they’re less financially strong, the risk of default is higher. In the event of a bankruptcy, bank loans typically have seniority over other debt, so holders are more likely to get their money back. Still, buyers of bank-loan funds should be prepared for a rough ride. How rough? In 2008, the funds lost almost 30%, according to Morningstar.

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