Opportunity in rising rates

Consider yourself pardoned if you failed to notice last week's launch of a big initial public stock offering with an unobtrusive name, the Eaton Vance Floating-Rate Income Trust.

The latest closed-end fund raised $680 million in an IPO a week ahead of tomorrow's Federal Open Market Committee meeting that will surely herald an era of rising interest rates, timing that was anything but coincidental. It received scant media attention.

But that new trust was the latest example of how Eaton Vance Corp. of Boston has turned ultralow interest rates and capital risk, two potential investment killers, to its advantage in raising billions in money to manage.

Creating investment vehicles as closed-end funds, instead of the conventional open-ended mutual fund form, is one key. Closed-end funds trade like stocks, involving transactions between a buyer and a seller. Open-ended mutual funds pay investors who want to redeem shares with cash out of the pool of invested money.

Eaton Vance has launched more than 20 closed-end funds over the past 2 years, a pace that places it among leaders like Nuveen Investments Inc. Those closed-end funds raised $11.8 billion, more than twice as much as Eaton Vance had in net sales of conventional mutual fund shares over the same period.

A pile of closed-end municipal bond funds managed by Eaton Vance and others hit the market in 2002 when people who depend on income from their investments struggled with extremely low interest rates.

Unlike mutual funds, those closed-end alternatives were able to borrow short-term money and invested it in more bonds. That had the affect of turbocharging returns of closed-end funds that were earning income on money raised from shareholders plus more borrowed cash. The total dividend still wasn't great, but it was much better than the income offered by comparable mutual funds.

That strategy became less appealing when interest rates began climbing sharply in March. Rising rates offer better interest on new debt issues, but they reduce the value of existing bonds. The higher rates climb, the bigger hit to the principal value of existing investments.

Eaton Vance and others have begun rolling out closed-end funds, like the trust launched last week, designed to protect the value of income-producing investments as rates rise. Those funds invest in loans, written by banks, that charge the borrower higher interest if market rates move up.

Like the closed-end municipal bond funds, these new bank funds borrow short-term money to boost the total amount invested for shareholders. There are drawbacks to the bank loan funds, including higher management fees and the risk that some borrowers won't repay what they owe. But the interest rates paid out by the bank loan funds should float up and down with the broad market and protect the principal value of their stockholders' investment.

So far this year, investment companies have launched about two dozen closed-end funds, raising more than $14 billion, and bank loan funds are the big favorites. ''Clearly there was more demand than we were able to meet," says Tom Faust, chief investment officer at Eaton Vance. ''Whether that would be the case when we would be ready to come back to the market, no one can say."

Closed-end funds can offer something more than mutual funds for some investors, but closed-end funds come with additional risks. A mutual fund share can always be sold at a price that reflects the value of the fund's investment. Shares of a closed-end fund can trade for more or less, depending on the demand from buyers at any given time.

Many of the closed-end municipal bond funds that were hot in 2002 trade at prices that reflect a discount of more than 6 percent now. Bank loan funds are so popular today that they trade at a premium, but will that be the case a year or two from now? Probably not.

Steven Syre is a Globe columnist. He can be reached at syre@globe.com.