By now, I am sure that you are familiar with the inverse relationship between bond prices and interest rates. When interest rates go down, as the have the past few years, bond prices go up. When interest rates go up, as they are now, bond prices go down. During the down market of 2000 to 2002, many investors loaded up on bonds for the safety vs. stocks. With interest rates increasing, many people are now seeing the value of their bond portfolios eroding. For them, there are two ways to enjoy the relative safety of bonds while protecting themselves from rising interest rates, stable value funds and bank loan funds.
Stable Value Funds
Anyone who has ever had a 401k plan is probably familiar with stable value funds. Just like traditional bond funds, these funds invest in a variety of bonds. They then take the extra step of purchasing insurance to prevent the share price from decreasing. Because of the insurance protection, the value of the fund will not go down, regardless of what interest rates do. The flipside is that if interest rates go down, these funds will lag traditional bond fund because of the insurance cost. Historically, these funds have only been available in 401k plans, but they are now available to all investors through mutual funds.
Bank Loan Funds
Bank loan funds, also known as prime rate or loan participation funds, invest in loans made by banks and other financial institutions to big corporations. The interest rates are floating and usually reset every 30 to 60 days. Because of that feature, the loans value tends not to decrease when interest rates increase. The loans that these funds invest in tend to be lower grade but are secured by the assets of the underlying company.
Another advantage of these types of funds is their low correlation to stock and bond markets. This could make them a valuable piece of a diversified portfolio.
Neither of these types of funds tends to be as liquid as traditional bond funds. Stable value funs usually impose a small redemption fee if the investor sells during the first 12 months. Bank loan funds often will only allow for redemptions and purchases on a quarterly basis.