The Federal Reserve may begin tapering off its easy money policy sometime in the next few months. So if you haven’t done so already, now may be a good time to explore hedges against rising interest rates. One of the most popular ways to hedge is through mutual funds that invest in “floating-rate” bank loans; their coffers have taken in more than $42 billion in new investment just in the past year. To get a better idea of how these loans work, I spoke with George Goudelias, manager of RidgeWorth Seix Floating Rate High Income Fund (SFRAX, 888-784-3863). George’s fund is up about 3 percent so far this year vs. a 2 percent loss for the bond market in general.

What exactly is a floating-rate loan?

It’s a shorter-term bank loan typically taken out by “leveraged” companies, those with a high level of debt and middling-to-low credit ratings.

The loan is almost always secured with the company’s assets and usually paid off within three years. Technically, this is a private placement, so it’s not a security governed by the SEC.

If the company runs into financial problems, the bank loan’s claim on assets is first in line, ahead of bondholders. Historically, bank loans have on average returned 70 cents on the dollar in case of bankruptcy, whereas high-yield bonds have returned about 40 cents.

Bank loans give companies a lot of flexibility, since they can be prepaid at any time. However, if the company needs to borrow back, it would have to structure a new deal.

What types of companies take out floating-rate bank loans?

A lot of household names. You’d be surprised. T-Mobile (NYSE: TMUS), for example; we own a bank loan to MetroPCS, which T-Mobile acquired. Clear Channel Media Holdings (OTC: CCMO), the nation’s largest radio broadcaster, is another one. Probably the best-known leveraged buyout (LBO) this year was that of Heinz, one of our larger positions. Yet another name we’ve been involved with is the Spanish-language broadcaster UniVision.

How are the rates set?

Bank loan rates are typically tied to the London Interbank Offer Rate (LIBOR), which is a benchmark interest rate used for short-term borrowing.

Bank loan interest rates are based on LIBOR plus a fixed amount of interest, depending on the credit quality of the borrower. Rates reset every three months, along with LIBOR, with some loans resetting every month.

Why are bank loans attractive right now?

The typical bank loan is yielding 5 percent plus now. And given the lack of competitive yields out there, I think a lot of people find this type of payout pretty attractive.

Also, bank loans yields aren’t much lower than those of junk bonds, but bank loans offer significantly more downside protection.

Recently, for example, we’ve seen long-term rates rise in the US. Bank loans haven’t been hurt nearly as much as bonds and other fixed-income securities, most of which are in solidly in the red year-to-date. Our firm’s high-yield bond fund was down about 2.7 percent in June, while our bank loan fund was down only 0.6 percent.

That’s because bank loan rates can potentially move up, although this hasn’t happened yet since short-term interest rates have remained static. LIBOR was 5.5 percent in 2007 and now it’s down to about 0.33 percent.

However, the interest rate increases people have been worrying about have started to come to fruition— not yet on the short end but on the long end.

Eventually, both short- and long-term rates will rise across the board. And during such times bank loans have what I call a “free option” on rising rates and inflation.

[In 1994, when rates rose across the board, leveraged funds were up 10 percent for the year vs. a 4 percent loss for Treasury bonds.]

Given that short-term interest rates have not moved up, why is so much new money going into bank loans, which are by nature short-term?

We’ll see the rates on bank loans adjust upward when short-term interest rates rise, which is bound to happen. And this can happen unexpectedly, especially if US job growth and GDP come in better than expected in the second half of 2013.

So it’s best to get in early. Just nine months ago, no one would have guessed that 10-year Treasury yields would be up 60 percent within a period of three months.

Bank loans, as an asset class, are selling pretty much at par. And so there’s not much price appreciation.

And theoretically, the downside is 100 points—a total loss. We saw a lot of names come pretty close to that in 2008.

So the key in this asset class is to protect your downside. Make sure you do good credit research, clip the coupon, and hopefully make a little more on top of this to generate a good return.

What is your outlook for short-term rates?

We’ve been in an artificially low rate environment and have lost perspective of how high rates have been in the past. In the early 1980s, I remember putting $500 in a bank CD paying out 16.5 percent!

However, the Fed has made it pretty clear it will not move the Fed funds rate [used to set short-term interest rates] any time soon, so that’s likely to remain in the zero to 0.25 point range.

With respect to the longer end, that’s more a function of the market deciding what rates should be and when the Fed might end its easy money policy. The talk of Fed tapering surely triggered this year’s rise in long-term rates. But economic growth is the primary catalyst for rising rates in the long run.

So when economic growth picks up strongly, you’re going to see the Fed raise the funds rate a bit and by extension short-term rates. And that’s when rates across the entire maturity spectrum are likely to go up.

At this point, what are the biggest risks to leveraged loan funds?

I would say the risks are more macro in nature right now.

Leveraged companies, the primary clients for bank loans, need US economic growth to support their capital structures, and that growth just isn’t really there.

Growth recently has been positive but not what you would see in a typically recovery.

So the biggest risk would be decelerating or even negative growth, which could lead to companies ultimately not being able to support their capital structures as well.

The second biggest risk pertains to any asset class, and that’s the global economic environment.

You’ve got Europe, for example, where things haven’t really gotten better, although there are signs of improvement. Certainly, the cost of borrowing for countries like Spain and Italy has declined dramatically, after the European Central Bank said it would do whatever it takes to keep them solvent.

What’s your outlook for the bank-loan market?

Without another recession, things should keep ticking along. Since bank-loan default rates peaked in 2009 at about 11 percent, they’ve declined to about 2 percent and have stayed low for quite some time.

Companies have streamlined their operations and are very reluctant to hire until they see their bottom line improving due to sales growth. So they’re lean, running very efficiently and they’re able to service their debt.

A huge help for corporations has been dramatically lower interest expense. Leveraged companies can now issue bonds at 5.5 percent and get bank loans at 4 percent. Five years ago, these rates would have been twice as high.

Say a company’s interest expense has gone from $150 million a year down to $70 million. That $80 million saved can now be used for capital spending, to expand the business or to pay down debt. Thousands of US companies have thus benefited.

As we enter a rising rate environment, should we expect to see more companies entering the bankloan market?

The trend in 2010 and 2011, which started to slow last year, was companies paying off their bank loans, which have more restrictive covenants than bonds. But lately, we’ve started to see some companies call in bonds and replace them with loans.

The interest savings isn’t monumental, but companies that are LBOs [leveraged buyouts] tend to prefer bank loans because many of their private equity investors have three- to five-year timeframes.

So while we don’t see any definitive trends, we can say the number of companies switching out of loans and into bonds has definitely slowed in the past few years.

We’ve also seen a slew of bankloan issuance just over the past month. Right now, the calendar for the next several months indicates issuance of about $47 billion. It was at $43 billion the week before, with a 52-week average of $35 billion.