Lured by 6% yields and the promise of inflation protection, investors are embracing risky "floating rate" mutual funds.
The funds, which invest in adjustable-rate "leveraged loans" made by banks to highly indebted companies, have seen inflows of $1.8 billion so far this year through May 23, after taking in $13 billion last year, according to investment tracker Lipper Inc. That compares with outflows of $3 billion this year and $94 billion in 2011 for stock mutual funds.
Fund firms have been rolling out new products to tap into the growing demand. Seventeen floating-rate funds have launched since 2010, bringing the total to about 40, according to Lipper Inc. Several firms are now planning to launch floating-rate exchange-traded funds, including Blackstone Group (BX)
What is the draw? With overall bond yields near all-time lows, leveraged loans still are paying generously. While the average leveraged loan pays 6%, yields can hit the double digits on loans made to the lowest-rated companies, according to S&P Capital IQ. That is well above the average 2.5% for investment-grade municipal bonds and the 1.77% on 10-year Treasurys.
What's more, the funds help protect nest eggs from inflation. Because the funds invest in floating-rate loans, their payouts rise alongside interest rates. For that reason, experts say, demand for floating-rate debt has been rising as yields on Treasurys and other bonds have dropped, forcing investors to look for higher yield in order to preserve their spending power, advisers say.
The core consumer-price index showed an annual inflation rate of 2.3% in April -- 0.6 percentage point greater than the average 10-year Treasury yield.
Floating-rate funds have gained an average 2.6% over the past 12 months and an average 11% a year over the past three years, according to investment research firm Morningstar (MORN) Inc.
In exchange for market-beating yields, though, investors might be taking on a lot more risk than they realize.
For starters, increased demand is making the loans more expensive -- and shrinking their yields. (Loans made to risky triple-C-rated companies, for example, paid as much as 47% during the credit crunch but currently yield 14%, on average.)
It also is making lenders more willing to give companies better terms on the loans, which often is bad news for investors, say advisers. For example, so-called covenant-lite loans, which come with looser repayment terms, now account for about 20% of the market, according to S&P Capital IQ. That compares to a 2007 peak of 25%.
Some advisers are skeptical. "Investors need to be worried about the credit quality in these short-term loans, says Tom Fredrickson, a financial planner at Altfest Personal Wealth Management in New York.
Maury Fertig, chief investment officer at Relative Value Partners, a wealth-management firm in Northbrook, Ill., is allocating no more than 5% of his clients' portfolios to leveraged-loan funds. Though he likes the funds as an inflation hedge, he also worries about losses if the economy goes into a recession.
"Most of the investment returns may have been made already," Mr. Fertig says.
Still, fans of the funds point out that these risky companies must pay back such short-term loans ahead of other debts. As result, the funds have higher recovery rates than traditional bond investors in the event of a default or bankruptcy.
Peter Tchir, founder of TF Market Advisors in New Canaan, Conn., is telling clients to put as much as 15% of their bond portfolios in leveraged-loan funds. He expects these funds to outperform in a slowly growing economy in which companies can easily make their debt payments.
Mr. Tchir likes the $565 million Invesco PowerShares Senior Loan Portfolio (BKLN),
Morningstar's picks for the category include the $10.2 billion Fidelity Floating Rate High Income