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There's been something of a mania surrounding bank loan funds in recent months. They enjoyed $46 billion in year-to-date net inflows through August, as investors increasingly (and desperately) have been seeking yield with interest-rate protection. But there's also been the predictable and reflexive pushback by critics whose cautions are largely reasonable, but sometimes overstated.

The money pouring into these things is an understandable phenomenon. Infinitesimal fixed-income yields are spurring people to go further out on the yield curve and deeper down into credit quality. But the former tactic is beset with interest-rate risk, as bond prices have an inverse relationship with rates. As rates rise, the value of bonds declines. And the longer the maturity, the greater the magnitude of the reaction.

The latter practice, taking on higher credit risk - which characterizes bank loan funds - is, in the opinion of some commentators, even more dangerous. In an article at CNBC.com that carried the over-the-top headline, "The Bond Market's Ticking Time Bomb," one adviser recently declared: "Interest rate risk, you lose the opportunity cost of yield; credit rate risk, you lose everything."

Well, okay, but that's only if high-credit-risk securities were to constitute "everything" in your portfolio. How about a little balance here; it doesn't have to be "either/or." After all, no reasonable portfolio allocation would be overweight high credit risk, just as it wouldn't be overweight high interest-rate risk. In other words, there may well be a place for bank loan funds in many individual portfolios, especially as we prepare for rising rates.

(Incidentally, the article cited above makes no case whatsoever for bank loan funds constituting a "ticking time bomb," as the title titillatingly suggests. Today's sensationalist headline writing has infected even once-mundane financial prose.)

Yes, bank loan funds are marked with more-than-average credit risk, because they invest in below-investment-grade corporate loans. They're comparable in credit quality to junk bond funds, and some advisers contend that they're even riskier. But that's debatable. Moody's trailing 12-month speculative-grade default rate was 2.9% in August, while the default rate for leveraged loans was 2.2%, according to the Standard & Poor's SP/LSTA index.

Moreover, the economy will improve at some point, likely in tandem with rising interest rates. With a better economy should come fewer defaults.

And yes, in the calamity of 2008 bank loan funds tanked by about 30%. But they rebounded by an even greater percentage the next year and have soundly beaten, on an annualized total-return basis, the benchmark Barclays U.S. Aggregate Bond Index every year since. And that's been during an era of still-declining interest rates. As rates begin to rise at some point in the next year or two, the paramount advantage of bank loan funds should reveal itself: the combination of impressive yield with almost nonexistent duration.

While bonds of every stripe carry exposure to rising rates, bank loan funds are floating rate securities, meaning the rates on the underlying loans are re-set every 30 to 60 days. That means that their prices have almost zero sensitivity to interest-rate fluctuations, a metric known as duration. (Example: If a bond fund has a duration of 5.25, a 1% rise in interest rates will cause the value of the fund to decline by 5.25%.)

But because bank loan funds regularly and frequently adapt to rate changes, they have virtually no sensitivity to them. Hence, their duration is effectively zero. As rates rise, so will the yields of these funds. That said, they might not rise immediately, due to a rate "floor" that could exist on some of the underlying loans. But, really, who cares if you miss a single-point increase when the yield is already so good?

How good? Well, a proxy for the class would be the PowerShares Senior Loan Portfolio (NYSEARCA:BKLN), an exchange-traded fund that seeks to mirror the S&P/LSTA U.S. Leveraged Loan 100 Index. Based on its latest (October) monthly distribution of 8.3 cents per share, BKLN's indicative annualized yield is 4.0%. By comparison, an ultra-short bond fund would likely yield less than 1.5% today and have a typical duration of, say, 0.5, which on a relative basis is a lot more than zero.

Of course, the higher yield for BKLN, which is now a large holding in my managed portfolio, is compensation for the corresponding credit risk, just as it is with the yields for junk bond funds. Let's compare the two classes:

The two largest junk bond index ETFs, iShares iBoxx High Yield Corporate Bond (NYSEARCA:HYG) and SPDR Barclays High Yield Bond (NYSEARCA:JNK), each yield about 5%, just a tad more than BKLN. But they have substantially higher durations of 4.25 and 4.43, respectively (as of the Nov. 8 closing). The bank loan fund yields almost as much and will retain much more of its value in a rising interest-rate environment.

Are we in that environment yet? No, rates are slightly higher than six months ago, but there's little expectation that they'll move further until Fed tapering speculation again heats up. Still, that time is coming, with popular estimates now suggesting Fed action in March 2014.

The time to prepare for rising rates is now, and a modest allocation to bank loan funds, a vehicle that mitigates rate risk, can be a prudent investment.

A final tip: Buy bank loan ETFs instead of closed-end funds. The ETFs are likely to sell at lower premiums to net asset value.

Source: Bank Loan Funds Needn't Be A Speculative Choice