Discover the surprising fixed-income category that gives you the most yield relative to risk. Earn 3% on your savings with little downside. Thinkstock By Jeffrey R. Kosnett, Senior Editor March 29, 2013 Pop quiz: Among all interest-paying investments, which one delivers the highest income relative to the amount of principal it will lose when interest rates rise? (As you probably know, rising rates cut the values of existing bonds because newer, higher-paying bonds are more attractive). If you're fluent in bond-speak, you can refashion my question to: Where do I get the most yield per unit of duration? See Also: 12 Stocks to Get Dividends Every Month Hint: The answer is not high-yield corporate bonds. That would be correct at times, but not today. Junk-bond yields have cratered to about 6% for individual bonds and to less — sometimes below 5% — for junk funds after expenses. That is paltry income for the amount of credit risk that junk bonds present (the risk that an issuer might default) and the growing interest-rate risk these bonds present as their yields plunge. Sponsored Content All right, give up? The answer is … floating-rate bank loans. I thank the creative minds at the Eaton Vance investment-management company for designing a chart that shows at a glance just how successful floating-rate loans are at delivering extra income with minimal interest-rate risk (see the company's September 2012 white paper). Nothing else even comes close. Mortgage-backed securities are a distant second. The typical nonleveraged, open-end bank-loan fund currently distributes between 3% and 4%. Better yet, the average duration of these funds is six months, tops — and in some cases just one month. And that's why these funds are unlikely to lose principal if rates rise. By contrast, a long-term Treasury bond with a similar yield has a duration of about 15 years. If you own one, or a government-bond fund with an average maturity of, say, 20 years, and bond yields rise one percentage point, you are destined to lose 15% of your principal. A bank-loan fund's net asset value would barely budge. Advertisement If you're unfamiliar with how these funds operate, imagine an ultra-short variable-rate junk fund — a category that doesn't exist. The loan funds buy pieces of syndicated credit lines that banks extend to companies with middling credit ratings, typically single-B or double-B. The subpar credit standing precludes these companies from establishing low-cost credit lines at the banks. But as long as the economy is okay, these companies rarely fall behind on their loan obligations — and if they do, loan investors are near the top of the creditors' pecking order. The funds pay you a different rate each month because banks re-price these loans every 60 or 90 days according to a benchmark, such as LIBOR. That enables the funds to deliver higher income when rates are going up without seeing their share prices drop — a welcome combination for savers who are looking for decent income but who worry about principal loss if inflation picks up and yields rise. Most floating-rate bonds yield at least 3%, though some funds yield less because of expenses. Bank lending is not riskless. During the 2008 financial meltdown, bank loans lost as much as one-third of their value, and so did the funds, because nobody knew from one day to the next whether banks would be able to continue extending credit. The borrowers depend on this money. If they are cut off too long, some will go bankrupt or at best find their business seriously disrupted. So even the best-run bank-loan funds, such as Fidelity Floating Rate High Income (symbol FFRHX) , got clobbered. In 2008, the Fidelity fund lost 16.5%, but that was far better than the performance of most bank-loan funds, which on average plunged 29.7%. Almost all of the losses occurred in the final four months of the year. But the recovery came quickly, and those losses have long been erased. If you regard the dark stretch of 2008 as a once-in-a-generation market disaster, you shouldn't fret that floating-rate funds will see a repeat. Since January 2009, Fidelity Floating Rate has experienced monthly losses of 2% or more just twice, and it made up both of those declines almost immediately. This is the pattern throughout the bank-loan fund category. And the funds' minimal durations strongly suggest that they will continue to remain stable. There are other good choices in addition to the Fidelity fund, which yields 2.7% (figures are as of March 27). T. Rowe Price Floating Rate (PRFRX) debuted in 2011 and now yields 3.1%. And DoubleLine Floating Rate (DLFRX) became available last February. Most other floating-rate funds levy sales charges, but a few of those sponsors also offer leveraged closed-end funds (which you trade like stocks). The closed-ends have higher expense ratios because of the cost of credit, but they'll pay out more and outperform the regular funds when there's a boom in bank loans. Advertisement Eaton Vance Floating-Rate Income Trust (EFT, price $17.72) is one of the best of the closed-end funds. Yielding 5.9%, it distributes more income than the regular funds because it borrows 37 cents for every $1 of assets to expand the portfolio. EFT's portfolio contains parts of more than 700 loans, as many as the Fidelity and Price open-end funds combined. The Eaton Vance fund trades for a 9.5% premium to its net asset value, a consequence of the category's rising popularity among yield-chasers. You would be wise to get it or any closed-end bank-loan fund when its shares trade closer to the fund's NAV. When markets turn inhospitable, the leveraged closed-end funds get crushed. For example, Nuveen Senior Income (NSL, $7.88) lost 48.9% in 2008 (it rebounded with a 139.3% total return in 2009). The fund sells at a 6.5% premium to NAV and yields 6.9%. If you only want the income, ignore the leveraged guys and choose a plain no-load bank-loan fund. Then you won't have to contend with a 49% loss if the markets disintegrate again. I would skip exchange-traded funds, however, because indexing isn't ideal in this category. You want to know that a fund's managers and analysts are on duty to vet hundreds of loans, reject the duds and negotiate better prices as the money flows in.