Floating-Rate Mutual Funds: Rewards And Risks

By David Allison AAA

When interest rates are low, fixed-income investors search for creative, sometimes riskier, ways to grab extra income. For this reason, floating-rate mutual funds attract the attention of both yield-hungry investors and the mutual fund companies that love to feed them. Read on to learn more about floating-rate mutual funds and some of the important points to consider before taking your first bite.

Floating-rate mutual funds can be both open and closed-end. Buyers beware, some floating-rate funds allow you to purchase shares daily, but will only allow you to redeem your shares monthly or quarterly. Floating-rate funds usually invest at least 70-80% of their investment holdings in floating-rate bank loans. The other 20-30% of the fund's holdings are commonly invested in things like cash, investment-grade and junk bonds, and derivatives. Many of these funds attempt to boost their yields by using financial leverage. You are more likely to see large amounts of financial leverage used in a closed-end floating-rate fund than an open-ended one.

Yields offered by floating-rate funds typically fall somewhere between yields on investment-grade bond funds and high-yield bond funds. Every mutual fund is structured differently with regard to its use of leverage, investment strategy, expenses and rules for both purchasing and redeeming your shares. As always, it is important to carefully read a mutual fund's prospectus before you invest.

Floating-Rate Bank Loans 101
When investing in floating-rate funds, it is important to understand the basics of floating-rate loans. Floating-rate loans are variable-rate loans made by financial institutions to companies that are generally considered to have low credit quality. They are also known as syndicated loans or senior bank loans. Borrowers enter into these loans to raise capital for things like recapitalizations, debt refinancing or to make acquisitions. After banks originate the loans they sell them to hedge funds, collateralized loan obligations (CLOs) and mutual funds.

The loans are called "floating-rate" because the interest paid on the loans adjusts periodically, usually every 30-90 days, based on changes in widely accepted reference rates, like LIBOR, plus a predetermined credit spread over the reference rate. The size of the credit spread depends on things like the credit quality of the borrower, the value of the collateral backing the loan and the covenants associated with the loan. Floating-rate loans are classified as senior debt, and are usually collateralized by specific assets, like the borrower's inventory, receivables or property.

The word "senior debt" is especially important here. It means that the loans are typically senior to bondholders, preferred stock holders and common stock holders in the borrower's capital structure. Not all floating-rate loans "float" all of the time. Some of the loans can be originated with options, like interest rate floors, which can affect the interest rate risk involved with owning the loan.

Key Qualities of Floating-Rate Funds

  • Junk Status and Seniority
    Because they generally invest in the debt of low credit quality borrowers, floating-rate funds should be considered a riskier part of your portfolio. Most of the income earned by the funds will be compensation for credit risk. Some of the credit risk involved with investing in the debt of low credit quality companies is offset by a floating-rate loan's capital structure "seniority" and the collateral backing it. Historically, default recovery rates on floating-rate loans have been higher than that of high-yield bonds, which has meant lower potential credit losses for investors. A diverse portfolio of floating-rate loans should perform well when the economy is recovering and credit spreads are tightening.

  • Limited Duration
    A floating-rate fund's net asset value (NAV) should be less sensitive to movements in short-term borrowing rates than other income producing mutual funds, like long-term bond funds. The maturity of a floating-rate loan is around seven years, but the underlying interest rate on most loans will adjusts every 30-90 days, based on changes in the reference rate. For this reason, the market value of a floating-rate loan will be less sensitive to changes in short-term borrowing rates relative to most fixed-rate investments. This makes floating-rate funds attractive to income investors in periods when the economy is recovering and short-term borrowing rates are expected to rise. (For more on duration see, Use Duration And Convexity To Measure Risk.)

  • Diversification and a Niche Market
    Floating-rate funds can offer diversification benefits to income investors. Because floating-rate loans are uniquely structured, they traditionally have low correlations with most major asset classes like stocks, government bonds, high-grade corporate bonds and municipal bonds.

    However, price correlations between floating-rate loans and other risky asset classes have been known to converge during periods of financial market stress. The floating-rate loan market is a fairly untapped, niche market to which most investors do not have direct access. These less-scrutinized markets can have their benefits. The less efficient the market, the bigger the opportunity for good fund managers to generate superior risk-adjusted returns. For this reason, it is especially important to check the investment manager's performance track record, tenure at the fund and experience investing in alternative assets before investing in a floating-rate fund.

Low interest rate environments can encourage investors to reach for extra yield with little understanding of the risk that they are assuming. The growing popularity of income-producing financial products, like floating-rate funds, makes it important for investors to be familiar with the basics of alternative asset classes. Floating-rate funds can provide income investors with diversification and some protection from interest rate risk. They can be an alternative (albeit riskier) way to add some extra income to your yield-starved portfolio. Just make sure that you are comfortable with their risks, and don't bite off more than you can chew. (For more on investing in alternative assets read, Alternative Assets For Average Investors.)

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