Higher interest rates are providing a windfall to the holders of prime-rate mutual funds, whose yields are surging even as net asset values are held steady.
The broker-sold funds strive to yield approximately the prime rate, yet maintain a stable net asset value -- in effect, to be supercharged money market funds, although with higher risks and costs and much less liquidity.
"This is a great investment for some kinds of people," said Colin Mathews, an analyst for Morningstar Inc. in Chicago. He said the funds appealed to conservative investors willing to tie up their money for an extended period; most of the funds have a back-end sales load of 3 percent, which vanishes after five years.
There are only five prime-rate funds, also called prime-rate trusts or loan-participation funds. Four, sponsored by Dean Witter, Eaton Vance, Merrill Lynch and Van Kampen Merritt, can be bought at net asset value -- the amount of the fund's assets divided by the number of shares outstanding -- at any time, but redeemed only periodically, usually once a quarter.
The fifth, Pilgrim Prime Rate Trust, is a closed-end fund traded on the New York Stock Exchange and is much riskier than the other four.
Prime-rate funds buy pieces of corporate bank debt, whose coupon floats at some premium to the prime, like 1.5 or 2 percentage points. Expenses bring the net yield back down to something approximating prime, which banks bumped up to 8.5 percent last month, from 7.75 percent. Rates on the loans are reset frequently, at least once a year and often every 60 or 90 days.
The funds strive to maintain a net asset value of $10 a share. And redemptions are restricted because their markets are much less liquid than, for example, government securities.
The loans themselves are usually originated by money-center banks. Borrowers are corporations with below-investment-grade ratings, and terms are typically three to seven years.
The risk in the funds is credit risk. When Best Products filed for Chapter 11 protection in 1991, for example, the Van Kampen Merritt Prime Rate Income Trust had to write down the $4.6 million balance on a $10 million loan to 53 cents on the dollar, and subsequently received only 51 cents.
The funds counter this risk in a number of ways, notably by restricting themselves to senior secured debt. They are first in line in the event of default, and loan balances are secured with assets of the borrowing corporation.
The funds spend heavily on research and diversify widely, participating in 50 or more loans and not investing, on average, more than 2 percent or so of assets in each.
"The numbers we've had in default are de minimus," said Jeffrey W. Maillet, manager of the Van Kampen fund. "We have had 750 different issues in the portfolio, and out of that we've had about 8 defaults."
Thus, while the net asset value is not guaranteed, in practice it usually does not vary from $10 by more than a few pennies. As of Nov. 25, net asset values ranged from $9.97 for Eaton Vance Prime Rate Reserves to $10.08 for Pilgrim, with Van Kampen at $10.04 and the Merrill Lynch and Dean Witter funds at $10.01.
But yields, which are typically paid out monthly, do vary, lagging changes in the prime rate as loans in the portfolio reset. On Nov. 25, for example, the Van Kampen payout rose to 7.6 percent, from 7.0 percent. The Eaton Vance fund, which had been yielding 5.90 percent in June, currently yields 7.24 percent. With the prime now more than a percentage point above that, yields at all of the funds appear headed up.
The six-year-old Pilgrim fund has consistently traded at a discount to net asset value that discount has been shrinking since early 1992 and ranged between 0.89 and 3.37 percent in the third quarter, partly because of a share buyback.
Although the fund has regularly been a top performer, it took several steps this year to lift returns, including changing its charter to allow it to invest up to 5 percent of assets in subordinated debt, and enable it to take larger stakes -- up to 100 percent -- in any one loan.
It also initiated a rights offering to raise $152.2 million, though the effect is to substantially dilute ownership of shareholders who decline to participate.
Michael McAdams, manager of the Pilgrim fund, said the initiatives did not represent major departures for the fund.
But Mr. Mathews, of Morningstar, termed them significant: "If you amend the charter to hold junior loans or subordinated debt, that's taking away protection you've had. I think you're stretching way too high for yield."
"Pilgrim Prime Rate is a great fund," he added. "We've got analysts here putting their mothers' money in it. But they're messing with it."