United States: Floating-Rate Bond Funds Offer An Alternative Yield Source

Last Updated: December 23 2014
Article by Steve Lewis

When interest rates rise, bond funds can suffer. If you are concerned about the potentially negative impact of rising rates on your portfolio, certain fixed-income investment strategies may help you manage the risk.

Floating-rate bond funds — also known as bank loan funds or senior loan funds — are one option to consider. These funds invest in floating-rate bank loans, which are short-term debt instruments with a variable interest rate. In fact, a floating-rate bank loan's variable rate provides one of a floating-rate fund's most attractive benefits: reduced interest-rate risk. However, these funds carry additional risks that you should carefully consider before investing.

Distinct from Traditional Bond Funds

As their name suggests, floating-rate bond funds are mutual funds or exchange-traded funds (ETFs) that invest in floating-rate loans. Unlike traditional bonds, which have a fixed coupon payment and therefore lose value as higher rates make newer issues relatively more attractive, floating-rate loans pay a variable interest rate that goes up when rates do, and vice versa.

The coupon of a floating-rate loan periodically adjusts at a fixed percentage above a predetermined benchmark rate, usually the London Interbank Offered Rate (LIBOR). Typically, the loans' rates reset every 30, 60 or 90 days, enabling them to reflect current market rates.

A second defining trait of floating-rate loans is that they are often issued to companies with lower credit quality — that is, those rated below investment grade — or that are unrated. As with high yield bonds, floating-rate loans offer relatively higher yields in exchange for the higher risk of default — or credit risk.

Unlike high yield bonds, however, floating-rate loans' credit risk is somewhat mitigated by their designation as senior-secured debt. This means the loans are at the top of the borrowing company's credit structure, as well as secured by company assets held as collateral. If the company defaults, it is required to pay back floating-rate loans first, ahead of its obligations to other bondholders and stockholders.

Higher Income Potential, Less Interest-Rate Risk

The unique characteristics of floating-rate loans provide some appealing benefits for investors, including:

Yield Potential — As previously mentioned, floating-rate funds seek a high level of current income by taking bigger credit risks. On average, these funds have offered higher yields than certificates of deposit (CDs), money market funds and bond funds of higher credit quality. Accordingly, they can be an attractive source of enhanced income potential.

Buffer Against Rising Interest Rates — Because the coupons of floating-rate loans reflect market rates, floating-rate funds have low sensitivity to interest-rate changes. If rates increase, these funds are less likely to decline in value than other types of bond funds.

Diversification — Historically, floating-rate loans have demonstrated low correlations to U.S. Treasuries and investment-grade corporate bonds — that is, they have tended to move out of sync with the types of bonds investors most often own. Assuming this trend continues, floating-rate funds may be able to lower the volatility of a core fixed-income portfolio, leading to smoother returns over time.

Consider the Trade-offs

Before investing in floating-rate funds, be mindful of their risks. For starters, in exchange for their lower interest-rate risk, floating-rate funds have higher credit risk. When the economy is expanding or credit conditions are favorable, companies have an easier time repaying their debts, making credit risk more manageable. During more challenging times, however, default rates can increase, which can lead to investment losses.

The floating-rate loan market is also small compared to other credit markets, which can make it less liquid at times and susceptible to declining loan prices. In such conditions, the value of your fund could fall. What's more, despite their historically low correlations with other asset types, floating-rate funds can see their correlations rise with stocks and other riskier asset types during periods of significant market volatility.

Review your Income Goals

When interest rates are expected to move higher, floating-rate funds tend to garner more attention because of their compelling track record during previous rising rate environments. In the past, the asset class has benefited as its coupons increased along with short-term market rates.

But keep in mind that, just as floating-rate coupons reset upward when market rates are rising, the coupons will decrease when market rates are falling. If your goal is to provide a consistent level of income over an extended period of time, other fixed-income options may better suit your needs.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Steve Lewis
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