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By Christine Benz and Russel Kinnel | 07-23-2015 03:00 PM

Can Bank-Loan Funds Shield You From Rising Rates?

These funds can offer higher yields when rates rise, but they aren't perfect hedges, says Morningstar's Russ Kinnel.

Christine Benz: Hi, I'm Christine Benz for Bank-loan funds were extremely popular in 2013, but flows turned the other way in 2014. Joining me to discuss the category is Russ Kinnel--he's director of fund research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Good to be here.

Benz: Russ, you wrote about the bank-loan category in the August issue of Morningstar FundInvestor. You talked about flows going in and out of the category. But before we get into that and maybe talk about some of Morningstar's favorite bank-loan funds, let's talk about what these funds do, for people who aren't familiar with them.

Kinnel: They invest in bank loans, which in some ways are similar to corporate debt. It's debt owed by a company. But because they are bank loans, (1) they don't trade as much, and (2) they have a feature that gives them appeal in today's environment, which is that the interest rate adjusts with changes in Libor. So, if interest rates rise, the yield on these loans will rise, which that means there's less interest-rate risk because the yields will rise, whereas normally in a regular bond, the yield is set at a certain level. So, if interest rates rise, that bond loses appeal.

Benz: Let's discuss flows because I think investors were perhaps attracted to bank-loan funds because of that very feature. They anticipated that rates were going to start to rise, so they flocked to these funds. We saw enormous inflows; more recently, though, we've seen outflows. Is this kind of the classic fear/greed cycle that we've seen with lots of other categories in the past?

Kinnel: I think a little bit. Performance hasn't been so extreme in either direction that you have tremendous reactions. But I think a little bit. For years, we've been talking about rising interest rates, so that's a logical selling point. But it means that bank-loan funds have really become big, whereas they used to be a pretty small piece. If you go back to '08, there was less than $10 billion total AUM in the bank-loan category. Fast-forward to 2013, and it's over $130 billion. That has actually come down a bit, but clearly there's a lot of appeal there. A lot of that is just people wanting to protect their bond portfolios from rising rates.

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