Considering a Floating Rate Fund? Here Are 8 Things to Keep in Mind
In times of rising interest rates, the popularity of floating rate funds also rises. Many investors view floating rate funds as a way to hedge against rising interest rates and inflation. Also, floating rate funds provide higher yields (roughly 4%) compared with money market accounts and CD’s.
If you decide to look into floating rate funds, here are 8 things to keep in mind.
- A floating rate fund is not a substitute for a money market fund. Floating rate funds are more risky that money markets and CDs. Floating rate funds lost up to 30% in value during the 2008 financial crisis. In order to get the higher yields from floating rate funds, investors take on more credit risk.
- Because lending banks can adjust interest rates every 30 -90 days, interest charged adjusts (floats) according to market conditions. This feature makes them an attractive option especially during a period of rising rates.
- Credit risk can be managed by good fund investment managers. Good floating rate fund managers usually take fewer risks in terms of what they buy for the fund (S&P BB and B) and diversify their holdings. This usually results in underperformance when compared to the average bank-loan fund but it reduces the volatility that most investors seek to avoid.
- Investors have the option of buying a floating rate ETF (Exchange Traded Fund) if they prefer ETFs to mutual funds. ETFs typically have lower expense ratios than mutual funds because they are not actively managed.
- In periods of falling interest rates, investors have to time their exit from the funds in order to realize the gains made during the times when interest rates rose.
- When demand for floating rate funds increases, supply also increases. In order to grow supply, lending standards can be lowered which increases default risk.
- Floating-rate loans are considered “senior” in a firm’s capital structure, meaning they typically have among the highest claims to a borrower’s assets in the event of default. This trait, combined with loan agreements that require firms to secure their assets with collateral, has led to higher recovery rates than for less-senior debt. (This does not reflect on the probability of default).
- They can help diversify short term investments. Common short term investments include money market funds and CDs (those that mature in less than 2 years). Given that a floating rate fund can adjust interest charged in 90 days or less, a floating rate fund can increase the overall yield of your short-term investments.
Like all investments, investors have to consider risk vs. return. Floating rate funds can be bought and sold at any time just like any mutual fund but investment managers do not consider them suitable for short-term trading.
Note: the information contained in this article is not offered as advice or guidance. Its purpose is illustrative – not instructive or prescriptive. As always, you should read the prospectus and seek professional advice when it comes to your financial decisions.
 A floating rate fund is a bond mutual fund that invests in bank loans of various durations (years) that feature variable interest rates (adjust every 30 -90 days). Funds invest in lower rated (i.e. riskier) companies. Higher risk is offset by higher yields and higher debt seniority in the firm’s capital structure.