IN ALL OF

the talk about the possibility of higher interest rates, nary a word has been said about bank-loan funds, an interesting and impressive asset class you've likely never heard of.

Although the market for senior loans is still relatively young, over the past decade the fund group has quietly established a strong track record in a variety of market environments. For open-minded investors willing to look off the beaten path, I believe now is an ideal time to consider an allocation to this underfollowed, inefficient and fundamentally attractive slice of the capital markets.

Perhaps one of the reasons bank-loan funds are still relatively unknown is that the financial-services companies can't settle on exactly what to call them. Some are marketed as "senior loan" funds, others as "prime rate," "loan participation" or "floating rate" funds. While the names differ, the investment strategy is generally the same.

Born out of the S&L crisis of the late 1980s, the funds invest in senior loans made to a variety of corporate borrowers. While the loans are often made to companies with less than perfect credit ratings, senior loans are, by definition, the highest ranking claim on a company's assets. In the event of a default or bankruptcy, the senior creditors get paid first.

Their most unique characteristic is that, unlike traditional bonds, which pay a fixed interest rate over a specific period of time, the loans held in bank loan funds' portfolios "float," meaning that they reset periodically based on a benchmark interest rate such as the prime rate or the London Interbank Offered Rate (LIBOR). The upshot? These are the only fixed-income investments I'm aware of that actually thrive when interest rates rise.

The results haven't been Cisco, but they've been solid. Since January 1992, the CSFB/Leveraged Loan Index experienced a negative monthly total return on only a handful of occasions. Given the booms and busts we've seen across markets over the past decade, bank loans' resilience is surprisingly remarkable. Even in 2000 and 2001, when credit-quality concerns pushed many companies' debt to junk status, the asset class as a whole held its ground.

Bank on It
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Data: CSFB Leveraged Loan Index Total Return From Jan. 31, 1992 through Aug. 31, 2003 (Source: Bloomberg)

Because the market is so new, the only way an individual investor can realistically participate is via a handful of mutual funds, most of which have been in existence for less than five years. Like most funds, there are both open- and closed-end versions from which to choose. But because bank loans are relatively illiquid, most of the open-ended funds have restrictions on making redemptions. Consequently, I prefer the closed-end ilk, which trade throughout the day like stocks and are thus, in terms of managing a portfolio, significantly more flexible. Also, since most of the closed-ends use ample leverage, the potential return (or loss) on these funds is dramatically greater than their relatively modest yields would imply.

For example, Citigroup Investments Corporate Loan Fund has gained more than 20% over the last year, not bad for an income fund whose yield is less than 5%. Eaton Vance Senior Income Trust has a slightly higher yield, and has also scored a one-year gain that puts most other income investments to shame.

I've watched these funds for quite some time, and one of the reasons I like them right now is that many are starting to trade at a premium to their net asset values for the first time in many years. This tells me that after years of simply ignoring them altogether, investors are finally starting to take note.

Unfortunately, the fund companies, as usual, are a little behind the ball. Although Pimco recently (and unceremoniously) launched the Pimco Floating Rate Income Fund, bank-loan funds are aren't just underpromoted among fund marketers they're downright ignored. This is an asset class in need of a PR agency big time.

In addition to the funds already mentioned, there are four other closed-end bank-loan funds of which I'm aware. The largest, Van Kampen Senior Income Trust and ING Prime Rate Trust, tend to be the most liquid, both trading several hundred thousand shares a day. The Nuveen Senior Income Fund offers a slightly higher yield than other funds but also tends to trade at a higher premium to its NAV. Probably the most unusual (and risky) option is the Salomon Brothers Emerging Markets Floating Rate Fund, which holds floating rate obligations from countries like Russia, Bulgaria and Peru. The fund is up more than 35% year-to-date.

Probably the biggest reason I'm excited about bank-loan funds is that, although the asset class is performing well, the public is still nowhere to be found. Search the message boards for any mention of bank-loan funds, and you won't find one. Yet the Cisco board still gets a thousand posts a day. You tell me where the herd is.

There's no investment that will compensate for a lack of discipline, prudence and patience. But you've got to bet on something, and as regular readers know, it often pays to look beyond the obvious favorites that dominate most investors' portfolios. And although the biggest factor in trading success is technique, not security selection, I believe that bank-loan funds, with their solid performance and absolute lack of buzz, constitute a smart long in today's market environment.

Jonathan Hoenig is Managing Member at Capitalistpig Hedge Fund LLC. At the time of writing, Mr. Hoenig's fund held positions in many of the securities mentioned in this article.