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The bond market’s ticking time bomb

Traders at the CME Group's Chicago Board of Trade
Tim Boyle | Bloomberg | Getty Images
Traders at the CME Group's Chicago Board of Trade

Despite their red-hot appeal, bank loan funds aren't on Brian Frederick's investment shopping list. A principal at Stillwater Financial Partners in Scottsdale, Ariz., the financial planner doesn't suffer from short-term memory when it comes to another rise in popularity for the asset class, which went over the cliff in the Great Recession.

"Bank loan funds got hammered in 2008 and 2009," Frederick said. Yet people thought they were safe because they held senior bank loans, which means they're the first to be repaid during defaults. Despite this cushion, bank loan funds lost 30 percent in 2008, according to Morningstar data.

Short-term memory seems to be fine for many, though. Afraid of rising interest rates, investors have stampeded into floating-rate bank loan funds this year. Assets have soared. The $49 billion put into bank loan funds in 2013 is more than flowed into them in the past eight years combined, according to Lipper data.

Bank loan funds are mutual funds made up of loans to corporations made by banks and other financial outfits. They are also called floating rate funds, because they don't pay a fixed interest rate but rather an adjustable one.

(Read more: The world's most expensive asset class)

The lure is those bank loans' short duration—30 to 90 days, "so there's no interest rate risk," said Sarah Bush, a senior mutual fund analyst at Morningstar. Another plus is that loans held by funds have a floor pegged to Libor, so yields reset when interest rates rise.

But Frederick isn't buying it, and he isn't alone in hesitating to follow the masses into bank loan funds in response to rising rates.

Experts worry that investors are ignoring the risks of low-rated bonds as default levels decline and the economy picks up speed. In August, the default rate for leveraged loans was 2.2 percent, according to Standard & Poor's SP/LSTA index. Yet Frederick and others argue that bank loans are arguably even riskier than junk bonds.

"These companies have a hard time even issuing junk bonds," Frederick said about bank loans.

Allan Roth, founder of advisory firm Wealth Logic, said taking on more credit risk to mitigate interest rate risk is not logical.

"Between credit risk and interest rate risk, boy, I would I rather take on rate risk," he said. "Interest rate risk, you lose the opportunity cost of yield; credit rate risk, you lose everything."

(Read more: The bond investor survival guide)

Roth, who avoids bank loan funds, does own a small percentage of high-yield bonds for clients, but he considers the high yield as a portion of his equities portfolios rather than part of the fixed-income allocation.

"I'm buying the best of junk, the nicest house in a bad neighborhood, and I bought it in 2008 when it was being run from, just a tiny bit," he said.

In the view of many financial advisors, fixed income should be a portfolio's shock absorber, and the last thing a client needs is a fixed-income holding that performs as poorly as equities if the market tanks: the 2008 scenario for bank loan funds.

"Even high-quality high yield is not a shock absorber," Roth said.

Bush worries that bank loans will sell off quickly if there's another flight to quality. She also noted that these investments have very little call protection. If called, the loans can be repaid at par, which means that investors who overpay can lose money.

(Read more: Silver lining in the bond market panic)

Though investors have been piling into bank loan products, they've started to bail on high-yield funds. So far this year, U.S. junk bond funds have had outflows of $11.8 billion, according to Lipper. The reason: Credit quality being somewhat equal, high-yield funds are exposed to interest rate risk, and that makes all the difference, even if default levels are similar.

Speculative-grade bonds still have low default rates, according to S&P estimates, and defaults should increase slightly, bumping up from 2.6 percent in June 2013 to 3.1 percent by June 2014. The long-term average has been 4.5 percent.

The market for companies with rock-bottom ratings is thriving. CCC-rated paper was up 7.56 percent through the third week of August, versus 2.4 percent for the overall high-yield market, according to a Barclays credit research report.

Jeff Tjornehoj, head of Lipper Americas research, explained by email that there hasn't been a big enough rise in investment-grade bond rates to warrant an exodus from high-yield funds, or from investment-grade bonds, for that matter.

(Read more: Obama's bid to pack the Fed may have hit a snag)

Nevertheless, bank loan funds are the riskier play of choice, and plenty of financial advisors are gravitating to the asset class as a source of income for clients.

"Advisors really like loan funds for their floating rate nature—it greatly reduces their interest rate risk so investors aren't burned in a rising rate environment. Still a credit risk, but with low rates elsewhere, they're stuck with this for income," Tjornehoj wrote.

Rick Ferri, founder of Portfolio Solutions and a certified financial advisor, said bank loans' popularity is little more than an elevator pitch to him.

"Bank loans are hot and the increase in rates has made them hot, and a hot product lasts a year or two and then blows up," he said. "Why does it blow up? We don't know, and that's the problem. We don't know what minefields are in it."

It's usually a good idea for fund investors to be wary of the herd mentality.

"The U.S. government issues, for right or wrong, 70 percent of taxable fixed income in this country, and for clients to have 10 percent in government bonds and 90 percent in 'the rest' is fairly reckless," Roth said. "That's the same stuff that blew up in 2008. Did it recover? Yes, Will it recover the next time? I don't know."

The question for fixed-income investors is, ultimately, straightforward: You can always find a way to increase yield, but should you?

The comparisons to 2008 can be a self-defeating prophecy, according to Tjornehoj. "If anyone thinks a replay of 2008 is around the corner," he said, "there probably aren't any good investments out there."

When the markets imploded five years ago, the total bond index fund gained roughly five percent, and a CD strategy was a better choice than a high-yield offering—a fact that makes Roth feel better about resisting the riskier credit funds.

Frederick isn't appeased, either.

"Junk bond investors aren't being compensated for the risk," he said. "Now is the time to stick to higher-credit quality bonds."

—By Constance Gustke, Special to CNBC.com

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