DEFINITION of 'Floating Rate Fund'

A mutual fund that invests in financial instruments with a variable or floating interest rate. A floating rate fund invests in bonds and debt instruments whose coupons fluctuate in line with the underlying level of interest rates, as opposed to fixed-rate coupons. The biggest advantage of a floating rate fund is its lower degree of sensitivity to changes in interest rates compared with a fund or instrument with a fixed coupon rate. Floating rate funds appeal to investors when interest rates are rising, since this will result in a higher level of interest or coupon payments. They are far less appealing when interest rates are declining.

BREAKING DOWN 'Floating Rate Fund'

The coupon rates payable on a floating rate instrument held within a floating rate fund will vary in line with a defined interest rate benchmark known as the reference rate. The reference rate that is used as a basis to adjust the coupon rate is generally a widely followed benchmark such as LIBOR (the London Interbank Offered Rate), the U.S. federal funds rate or the prime rate.

Apart from their lower sensitivity to interest rate changes and ability to reflect current interest rates, a floating rate fund enables an investor to diversify fixed-income investments, since fixed-rate instruments comprise the majority of bond holdings for most investors. Another benefit is that a floating rate fund enables an investor to acquire a diversified bond portfolio at a relatively low investment threshold, since most bonds are only available in large dollar amounts. A floating rate fund may also mitigate credit risk by holding bonds from a number of issuers. This diversified fund portfolio may have a lower degree of credit risk compared to a fixed-income portfolio that only has a couple of issuers.

In evaluating a floating rate fund, investors must ensure that the bonds the fund holds are adequate for their risk tolerance level. For example, an 80-year-old investor whose primary objective is capital preservation would be ill-advised to invest in a floating rate fund that invests primarily in speculative-grade bonds, since it may be susceptible to a higher degree of credit risk and significant price volatility.

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