Individual investors are putting more money into bank-loan funds, taking added risk in a search for higher yields and a hedge against inflation as the Federal Reserve vows to keep interest rates at near-record lows.

U.S. floating-rate funds in April had the biggest inflows in 11 months, according to preliminary data from EPFR Global, a Cambridge, Massachusetts-based research firm. Investors poured $729 million into the funds, the most since $2 billion last May. The funds buy speculative-grade loans, a type of floating-rate debt that ranks senior to bonds and is used to finance buyouts.

"Where else can you get 4 percent to 5 percent with zero duration? Few places, as far as I know," said Christopher Remington, institutional money manager for Boston-based Eaton Vance Corp. (EV), which oversees about $24.7 billion in floating-rate loans for retail and institutional investors. Duration is a measure of interest-rate sensitivity. Most fixed-income investments fall in value as interest rates rise.

The Fed has pushed investors into riskier corporate credit by suppressing long-term rates on safer Treasuries under a $400 billion bond-buying program known as Operation Twist. To aid the economic recovery, the central bank has also kept its target interest rate within a record-low range of zero to 0.25 percent since December 2008.

The underlying loans returned 5.57 percent this year through May 4, compared with 3.08 percent through the same period of 2011, according to the Standard & Poor's/LSTA U.S. Leveraged Loan 100 Index. The funds that buy them aren't immune to losses.

Yields and Risk

That's because the funds buy loans whose higher yield is accompanied by higher credit risk. Leveraged loans are rated below Baa3 by Moody's Investors Service and less than BBB- by S&P. The debt's interest rate generally resets on a quarterly basis.

Some advisers say that's an advantage if rates rise, such as in response to a pickup in inflation, although holders could be left in line with other creditors if borrowers default.

"I think it's a sweet spot right now," said Maury Fertig, chief investment officer of Relative Value Partners LLC, which manages about $650 million on behalf of individual investors and wealth managers.

"When stacked against other fixed-income assets I think at least I have the opportunity for some capital appreciation, and in the event of higher rates I'm not going to lose a tremendous amount of principal," said Fertig. Bank loans account for about 15 percent of his clients' fixed-income portfolios at the Northbrook, Illinois-based firm.

2008 Declines

Bank-loan mutual funds lost about 30 percent during 2008, compared with about a 26 percent decline for funds that invest in high-yield bonds, according to data from Morningstar Inc. (MORN), a Chicago-based research firm. This year through May 3 loan funds have gained about 4.8 percent, compared with 6.8 percent returns for high-yield funds.

Yields on 10-year Treasuries were 1.88 percent at 1:50 p.m. in New York, compared with about 3.15 percent a year earlier. Inflation was about 2.7 percent over the 12 months through March before seasonal adjustment, according to the Bureau of Labor Statistics.

Fertig said he likes that the loans have less interest-rate risk than many other fixed-income investments, because of their ability to reset rates, and that recovery rates on defaults are on average higher than those of traditional high-yield bonds.

Stronger Protections

Investors on average recovered about 66 percent of their principal on bank loans in default from 1991 to 2012, compared with a recovery rate of about 41 percent on high-yield bonds from 1983 to 2012, according to a JPMorgan Chase & Co. (JPM) research report.

The loan funds offer attractive income and stronger protections in bankruptcy than some other types of high-yield debt, said Jonathan Bergman, chief investment officer of Scarsdale, New York-based Palisades Hudson Asset Management LP, which oversees more than $1 billion.

Not all advisers are stocking up.

"People are so starved for current yield that I think it's pushing them into spots they otherwise wouldn't go," said Mark Balasa, chief investment officer for Itasca, Illinois-based Balasa Dinverno Foltz LLC, which manages more than $2 billion. "In 2008 these things got shelled."

Correlated With Stocks

Leveraged loan prices plunged to 59.2 cents on the dollar in mid-December 2008, as investors were dumping risky debt two months after the collapse of Lehman Brothers Holdings Inc. deepened the worst recession since the Great Depression. They averaged 94.37 cents on May 3, which was the highest since July 29, according to the S&P/LSTA U.S. Leveraged Loan 100 Index.

Investors buying bank loans may not realize that the loan prices tend to be correlated with stocks, said Douglas Anderson, a director in Palo Alto, California, with Harris MyCFO LLC, which manages about $20 billion on behalf of families and is a unit of Bank of Montreal.

"The more you take out of traditional high-quality fixed income, the more exposure you'll have in the event of a significant market correction," Anderson said.

The Financial Industry Regulatory Authority, the securities industry's self-funded regulator, in July issued an investor alert warning investors about purchasing complex products, including floating-rate loan funds, that may promise higher returns than traditional investments.

Significant Risks

"Funds that invest in floating-rate loans may be marketed as products that are less vulnerable to interest rate fluctuations and offer inflation protection, when in fact the underlying loans held in the fund are subject to significant credit, valuation and liquidity risk," Finra said in the alert.

JPMorgan in November was ordered by Washington-based Finra to reimburse customers almost $500,000 for losses stemming from unsuitable sales of floating-rate loan funds. Tom Kelly, a spokesman for the New York-based bank, declined to comment.

"When everyone is concerned about yield, and return, and growth, rather than risk, especially on an asset like fixed income, it invariably leads to bad outcomes," said Joe Duran, chief executive officer of Newport Beach, California-based United Capital, which advises on about $14 billion.

A decline in mergers and acquisitions left fewer opportunities for new loans backing deals during the first quarter, while speculative-grade companies owned by private- equity firms tapped the loan market to pay shareholder dividends at the fastest pace in a year.

Piling on Debt

Buyout firms' practices of piling debt onto companies they own to extract payouts may reduce the credit worthiness of borrowers.

SeaWorld Parks & Entertainment Inc., the Orlando, Florida- based amusement-park operator and home of Shamu, the killer whale, was downgraded by S&P after getting a $500 million loan in March to fund a distribution to owner Blackstone Group LP. (BX) SeaWorld's credit rating was lowered to B+, four levels below investment grade, from BB-, because of the increase in leverage following the dividend.

The Fed said in January that economic conditions may warrant keeping rates "exceptionally low" through late 2014, extending a previous pledge to do so until the middle of 2013.

"The bias would be for a higher-rate environment and it is Fed policy that is keeping rates suppressed," said Christine McConnell, who manages the $10.2 billion Fidelity Floating Rate High Income Fund. (FFRHX) The fund has returned 3.27 percent this year, according to data compiled by Bloomberg.

Get in Now

"When interest rates really look like they're about to rise, investments such as this become very scarce and very expensive. I'd rather get in now when you have an asset class that may be a little bit cheaper, and that's paying you to sit around and wait," said Cam Albright, director of asset allocation at Wilmington Trust Investment Advisors, a unit of M&T Bank Corp. (MTB)

Client portfolios may hold about 2 percent to 3 percent in bank loans, said Albright, who's based in Wilmington, Delaware. The firm has built the positions since the beginning of the year as economic improvement has enhanced the appeal of holding securities with credit risk, he said.

U.S. floating-rate funds had $1.02 billion of inflows this year through May 2, according to EPFR, compared with withdrawals of $8.8 billion in the second half of 2011.

Mutual funds bought about 19 percent of new leveraged loans sold to non-bank lenders in the first quarter, compared with 16 percent in the last three months of 2011, data from S&P Capital IQ Leveraged Commentary & Data show.

Top Funds

The best performing bank-loan fund this year is the Pyxis Floating Rate Opportunities Fund (HFRAX), with returns of 7.36 percent through May 3, according to Morningstar. ING Senior Income Fund (XSIWX) ranks second, with a 7.3 percent gain.

The debt may provide less protection against rising rates than some investors realize, since some loans have interest-rate floors that are boosting yields, said Chris Cordaro, chief investment officer of Morristown, New Jersey-based RegentAtlantic Capital LLC, which manages about $2.2 billion. Payouts on such loans may take longer to increase if interest rates start to rise, he said.

"If you're buying this thinking you're hedging away your duration risk, you might be in for an awakening," Cordaro said.

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