PRIME RATE FUNDS

      BY RICHARD M. Colombik, JD, CPA 
 
 
 

Do your bonds have you feeling shaky since interest rates have no where to go but up? 

Interest rates are proceeding slowly upward from their 45-year lows, while, the Federal Reserve has retained extremely low short term rates.  In fact many money markets are yielding from .5 ? 1.0%.  Hardly a way to make ends meet if rates have such a low return.  Add to this the signs in economic improvement that means if interest goes up, the face value of your fixed bonds and bond funds will go down.  What can you do to increase your yield from a bond fund, without losing your principal?  After all prime rate is 4.00%, why can?t you get a better yield like a point or two above prime? 

It is a good thing that Prime Rate funds are available!   

Prime rate funds are funds that invest in portfolios of bank loans, usually made by large commercial banks and insurance companies to corporations that are normally not investment grade, but above a junk rating.  The loans are not public and do not trade on an exchange, though the prime rate funds themselves are offered by various mutual fund companies.  The loans are normally senior loans, that are secured by the company?s assets, so that even if there is a default, there is some recovery to the fund, because the loan is secured, the fund  is a secured lender. (By the way there has not yet been a major default within the prime rate fund sector) 

The rates are floating and tied to the prime rate.  Therefore if the prime rate goes up, with the improving economy, the actual yield on the bond fund goes up!  Conversely if rates go down the fund yield adjusts downward, and the principal value of your investment generally does not fall as it would on a fixed rate bond.  Yields also tend to actually be a few points better than prime due to the nature of the investment.  The net asset value of the accounts stays relatively constant, unlike a fixed bond portfolio.  This eliminates a major concern of fixed investment funds, the loss of principal. 

What is the downside? 

1. Fees
2. Declining Interest Rates
3. Liquidity

Fess charged to these types of funds tend to be higher than on most type of municipal or bond funds.  The fund houses argue that they have to do far more extensive research, than one would with a fixed bond portfolio.

Even net of the larger fees, yields are still quite attractive  

Second, as noted above if interest rates decline your yield declines.  This does not mean that your principal value declines, as most funds try to maintain a constant net asset value, but your actual return on investment could decline.  Conversely, if you believe interest rates have no where to go, but up, then your return would increase.  Remember these loans are not government insured and there is a risk. 

Third, unless you are in a publicly traded fund you may be limited to quarterly redemptions.  As prime rate funs have become more popular, more large funds have entered the fray and liquidity does not appear to be as much of an issue as it has in the past.  You must however, remember, that due to the small market for the fund to resell company loans to free up cash it could present a problem   if too many investors wanted to cash out at the same time, you may be limited on how quickly and how many shares you could redeem Conversely, the funds allow investors to buy in at any time.   

So where do Prime Rate funds fit in? 

The yield is greater than Treasury bills and do not have the risk of junk bonds.  They are reasonably conservative and provide a hedge against inflation and rising interest rates.  They definitely deserve a look at being a component of your bond or fixed income portfolio to help improve yields in a time of potentially increasing interest rates.