With interest rates rising, bond funds are falling. Many investors are moving to prime-rate funds instead. Before jumping into this trend, though, take a good look at the risks.
Prime-rate funds, also called bank loan funds, buy corporate bank loans, whose interest rates float with the prime rate. The thinking goes that, when interest rates rise, so do the returns on these funds. Sound too simple and too good to be true? In a way it is. “Whenever something becomes popular, by the time the average investor finds out, it’s too late [for the initial big returns],” says Joe Halpin, a certified financial planner and CEO of J.P. Halpin.
One of the first caveats to prime-rate funds is realizing they buy loans made to companies below investment grade (meaning they’re not the most creditworthy). Unlike junk bonds, though, the loans are secured by corporate assets. Another problem is lack of liquidity; investors can only redeem prime-rate funds quarterly. One last problem is fees: They tend to be higher than traditional corporate or government bond-fund fees by as much as a percentage point. Bottom line? “They’re very good for an institutional investor with a substantial portfolio,” advises Halpin. “But when you chase rates, you have to take a higher risk to get a higher rate. And for the average investor, I think the rewards aren’t worth that risk.”