One more time?

That’s the big question on the mind of everyone watching the Federal Reserve right now.

Whether or not the Fed will raise rates another quarter point has serious economic implications. At a minimum, the consensus right now seems to be “higher for longer,” whatever the “terminal” rate ends up being.

As I’ve pointed out before, the Fed has a dual mandate to stabilize prices and maximize employment. And right now, the stabilizing prices part is nearing its end.

But that doesn’t mean rates will start heading lower anytime soon.

Everything with a yield attached to it has had a rough go in this environment. From preferreds to corporate bonds and municipal bonds — even stocks, to an extent. At some point, the yields will be too good to pass up, and prices will rise again. But right now, there’s one asset class that directly benefits from high rates.

I’m talking about bank loan funds.

Bank Loan Funds: A Refresher

I wrote about these under-the-radar funds about a year ago. You may have heard of them as senior, prime-rate, syndicated, or floating-rate loans. Whatever the case, these are loans typically made to sub-investment-grade companies with less than stellar credit.

Some credit risk is involved because the borrowers don’t have the strongest balance sheets. But that risk is mitigated by restrictive covenants, which prevent the borrowers from taking any action the bank feels detrimental to getting its principal back. Second, whereas most bonds are unsecured, these are backed by tangible collateral such as property, equipment, and inventory.

The banks are the senior lenders, so they’re first in the pecking order of creditors. But defaults are pretty rare, running around 2%.

Now, here’s the part where income investors should perk up…

The rates on these loans are variable (or floating) rather than fixed. Most are linked to a short-term benchmark such as the London inter-bank offered rate (LIBOR), plus an extra 4%.

Here’s what the 3-month LIBOR has looked like lately…

For the record, that’s 125 basis points higher than when I talked about bank loan funds last year. And in January 2022, the LIBOR was at a paltry 0.2%. That’s quite the change in such a short period of time.

As short-term rates rise, so will bank loan yields (interest rates reset every 30 to 90 days). Of course, the reverse is also true in a falling rate environment. But remember, the current talk is about whether we’ll see one more hike and/or for how long rates will stay high. It may be a while yet before we see falling rates. So there is still a window of opportunity here.

My Favorite Pick Yields 12% Right Now

I’ve mentioned a few names to consider in previous articles, but my favorite is BlackRock Floating Rate Income Trust (NYSE: BGT).

It narrowly focuses 80%-95% of its roughly $300 million in assets in this unique space. Launched in 2004, this fund gets a coveted five-star rating from Morningstar.

The portfolio is well diversified across over two dozen industries, including auto parts, construction, software, healthcare equipment, and wireless telecom. The largest holding accounts for just 1.57% of assets, so there is minimal risk associated with any single issuer.

Like all floating rate funds, most of BGT’s assets reside a couple rungs below investment grade on the credit-quality ladder. But most are backed by established, well-known corporate borrowers. BlackRock’s credit research team is highly regarded, and the portfolio is skewed toward higher-rated B and B+ issues and away from the CCC stuff.

The average loan in the portfolio currently has a coupon of 8.4%. But remember, these loans reset every two to three months. So, you will still need to monitor which way the interest-rate winds are blowing.

The most recent monthly distribution was $0.114 per share, good for a fat forward yield of 12%. That’s more than double what you would get from a 10-year Treasury.

Action To Take

Any investor looking for a solid high yield in this market should be looking at bank loan funds.

With a low correlation to traditional fixed-income groups, BGT can also be an effective diversification tool. As an added bonus, the fund’s 3-year average discount to net asset value (NAV) is about 7%. That gap has widened to 10% of NAV, so new investors are getting a deal.

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