These Funds Are Immune to Interest Rates

They say that beauty is in the eye of the beholder — and I suppose that’s just as true in the financial world as anywhere else.

For most, the Fed‘s unprecedented string of stimulative rate cuts couldn’t have been better timed. Low interest rates make it easier for consumers to finance big ticket purchases.

That’s why traders typically cheer each time the Fed Funds rate is lowered a notch or two. In fact, unexpected cuts have triggered triple-digit rallies in the Dow.

But if you’re part of the fixed income crowd, you probably see things a bit differently. Lower rates mean lower yields on your investments. Money markets and savings accounts pay next to nothing. A 3-month Treasury will get you a negligible 0.01%. At that rate, a $10,000 3-month Treasury will generate a grand total of $1 in interest.

Another option is moving farther out on the yield curve. According to Bankrate, 5-year CDs offer 2.85% and 20-year AAA corporate bonds pay up to 5.22%.

But I’d avoid both right now. Because when interest rates start climbing, you’ll be locked in and unable to move your money — unless you don’t mind paying early withdrawal penalties or selling your bond for much less than you paid for it.

But what if you could get payouts above 4% without having to tie up your cash through 2029, or even the next three months?

I’m not going to spend too much time today trying to convince you that interest rates are headed higher.

The Fed Funds rate has been slashed to near zero, so there’s really only one direction rates can go — and that’s up.

We’re only here now because the Fed had to dispense an emergency dose of monetary drugs to keep the U.S. economy from flat-lining. But the patient has begun to recuperate, and sooner or later the Fed will have no choice but to stop the medicine.

Keep in mind, we have a long way to go just for interest rates to return to normal — let alone elevated levels needed to choke off inflation. So once the rate tightening cycle begins, don’t expect to see just one or two quarter-point hikes. The last time rates sunk to 1.00% in 2004, they were ratcheted upward 17 times during the next two years — to a peak of 5.25% in 2007.

This doesn’t paint a pretty picture for bonds, which move inversely to interest rates. But there is one unique class of securities built for this exact environment — floating rate loans.

Floating rate funds go by many names: Prime rate, senior loan or sometimes bank loan participation. Whatever you choose to call them, these funds all contain pieces of syndicated loans that large banks like JP Morgan Chase (NYSE: JPM) issue to corporate borrowers.

As you know, banks profit by offering depositors low rates, then loaning that money out at much higher rates and pocketing the spread. With these funds, investors like you and me have a rare opportunity to invest alongside the bank. This was once the exclusive domain of large institutions — retail investors weren’t access until 1989.

The loans come with a number of perks. These funds offer compelling spreads over other types of bonds since underlying rates are tied to benchmarks such as the Prime Rate or the London Interbank Offered Rate (LIBOR). Default rates are quite rare, historically averaging less than 2%. In the event of liquidation, these loans carry the highest claim on assets, followed by subordinated debt, preferred stock and then common stock. So even when there’s trouble, investors typically recoup $0.80 on the dollar — double what junk bond holders may get.

While that assurance is nice, it’s not what makes these funds so attractive in today’s market. The real selling point is that interest rates tied to these loans are variable, not fixed. Floating rate bank loans ratchet higher to adjust to rising interest rates — yields typically reset every 30-60 days.

Funds that hold these loans aren’t just immune to rate hikes, they actually benefit from them. Each time the Fed tightens the screws, your dividends get a little bit fatter.

Back in 1994, when short-term rates were lifted six times, the average bond fund fell -3.3%, while floating rate funds posted a gain of +6.1%. The same thing happened again in 1999.

I think we’ll see a more extreme version of this scenario play out during the next two years.

All the signs are lining up in favor of floating rate funds in 2010. Aside from the prospect of rising yields, keep in mind that these loans (like any debt) are affected by credit quality. Improved balance sheets and rebounding cash flow could lead to a series of upgrades in the year ahead.

P.S. After evaluating all the contenders, I’ve found one fund in particular that has the most to offer investors right now: Nuveen Senior Income (NYSE: NSL). For my complete analysis — and to see how you can profit from this unique investment vehicle, visit this link.