Floating Rate Funds: A Guide to Variable Rate Investing

Floating rate funds invest in debt securities with variable interest rates that adjust periodically based on market benchmarks. These funds have gained attention as investors seek income strategies that can adapt to changing interest rate environments while managing portfolio risk.

What Are Floating Rate Funds?

Floating rate funds are mutual funds or exchange-traded funds that primarily invest in bonds and loans paying variable interest rates. Unlike traditional fixed income investments where interest payments remain constant, these funds hold securities with rates that reset periodically—typically quarterly—based on short-term benchmark rates such as the Secured Overnight Financing Rate (SOFR).

According to the Federal Reserve Bank of New York, SOFR represents the cost of borrowing cash overnight collateralized by Treasury securities and serves as the primary benchmark for floating rate products since replacing LIBOR in 2023.

These investments typically include corporate bonds and bank loans that have been securitized into tradable instruments. Most floating rate funds allocate 70-80% of their portfolios to floating rate bank loans, with the remaining 20-30% invested in supplementary holdings such as cash, investment-grade bonds, and derivatives to enhance liquidity and manage risk.

How Floating Rate Funds Work

The mechanics of floating rate funds center on the relationship between benchmark rates and coupon payments. When short-term interest rates rise, the interest paid by the underlying securities increases accordingly. This adjustment typically occurs every 30 to 90 days, allowing the fund’s income to track current market rates.

Understanding the Spread Structure

Most floating rate securities calculate interest as a baseline reference rate plus a fixed spread. For example, a security might pay “SOFR + 250 basis points.” If SOFR is currently 4.30%, the security would pay 6.80% (4.30% + 2.50%). When SOFR adjusts quarterly, the coupon rate adjusts to reflect the new benchmark rate while the 250 basis point spread remains constant throughout the life of the security.

The spread—measured in basis points—remains constant and reflects the credit risk of the borrower. As the benchmark rate changes, the total interest payment adjusts while maintaining that predetermined spread. This structure allows investors to benefit from rising rates while the fixed spread compensates for credit risk.

Fund managers actively select and manage portfolios of these variable rate securities, evaluating credit quality, interest rate sensitivity, and income potential. This active management approach distinguishes floating rate funds from passive fixed income investments.

Types of Floating Rate Funds

Floating rate funds can be categorized based on their duration objectives and investment strategies, each serving different investor needs and risk tolerances.

1. Short-Term Floating Rate Funds: These funds focus on highly liquid instruments with maturities under one year, including government securities and Treasury bills. They offer lower risk and greater liquidity but typically provide more modest yields. Short-term funds are suitable for investors prioritizing capital preservation and easy access to funds.
2. Medium-Term Floating Rate Funds: Medium-term funds invest in instruments with one to three year maturities, balancing liquidity considerations with yield enhancement. These funds represent a middle ground between safety and income generation, appealing to investors with moderate risk tolerance.
3. Long-Term Floating Rate Funds: Long-term funds hold securities with maturities exceeding three years, primarily invested in floating rate bonds with partial allocation to money market instruments. While offering higher income potential, these funds carry increased credit risk and may have more restrictive redemption terms.
4. Open-End vs Closed-End Structures: Floating rate funds are available in both open-end and closed-end structures. Open-end funds allow daily purchases and redemptions at net asset value, providing greater liquidity. Closed-end funds trade on exchanges like stocks and may use more leverage to enhance returns, though they often restrict redemption frequency to monthly or quarterly windows.

Floating Rate Funds vs Fixed Income Investments

Fixed income investments offer predictable, stable interest payments throughout the life of the bond. However, their market value can fluctuate significantly when interest rates change. When rates rise, fixed rate bond prices typically decline to compensate for the difference between their coupon and current market rates.

Floating rate funds respond differently to rate movements. Because their interest payments adjust with market rates, their principal values tend to remain more stable compared to long-term fixed rate bonds. This characteristic makes them potentially attractive during periods of rising or volatile interest rates.

As noted by the Securities and Exchange Commission, interest rate risk is common to all bonds, and understanding how different bond types respond to rate changes is essential for fixed income investors.

The total return from bond investments comes from both interest income and price changes. While fixed rate bonds may experience price volatility, floating rate investments typically show less price movement but offer variable income streams that reflect current market conditions.

Comparing Floating Rate Funds to Common Alternatives

Understanding how floating rate funds compare to other fixed income options helps investors make informed allocation decisions within their portfolios.

Money market funds prioritize capital preservation and daily liquidity but offer the lowest yields. Floating rate funds provide a middle ground with higher income potential and reduced interest rate sensitivity, though they carry more credit risk. Short-duration high-yield bonds offer comparable yields with different risk profiles, while investment-grade bonds provide lower yields with less credit exposure but greater interest rate sensitivity.

Benefits of Investing in Floating Rate Funds

1. Reduced Interest Rate Sensitivity: Floating rate funds generally exhibit lower duration than traditional bond funds, meaning their values are less sensitive to interest rate changes. When the Federal Reserve raises rates or market expectations shift, these funds can adjust more smoothly than fixed income alternatives.
2. Portfolio Diversification: The unique characteristics of floating rate securities often result in low correlation to major asset classes. These funds can provide diversification benefits within a broader investment portfolio, particularly for investors seeking alternatives to traditional stocks and bonds. Similar to real estate as part of a diversified portfolio, floating rate funds offer distinct performance patterns.
   
   Using floating rate funds can help manage default risk through diversification across multiple issuers. This approach may serve as a tool in retirement planning strategies focused on balancing income stability with investment risk.
3. Income Potential in Rising Rate Environments: When interest rates increase, floating rate funds may offer higher income payments compared to fixed rate alternatives. This potential for rising income can be appealing to investors concerned about inflation eroding purchasing power.
   
   However, it’s important to recognize that the opposite also holds true—when rates decline, the income from floating rate investments typically decreases as well. Investors depending on consistent income, such as those learning how to live off interest, should carefully consider this variability.
4. Superior Recovery Rates on Defaults: Historical data shows that floating rate loans have achieved recovery rates of 60-70% following defaults, compared to 40-50% for high-yield bonds. This higher recovery rate stems from the senior secured position that many floating rate loans hold in the borrower’s capital structure, often backed by collateral that provides an additional layer of protection.

Risks and Drawbacks of Floating Rate Funds

• Credit Quality Concerns: The credit quality of floating rate funds has declined over time. According to the S&P LSTA Leveraged Loan Index, 69% of holdings are now rated B or lower, compared to 46% in 2010. This shift toward lower-quality borrowers increases default risk, making credit selection and active management increasingly important.
• Higher Expense Ratios: Many floating rate funds charge higher annual fees than standard bond funds. These expense ratios can reduce net returns, particularly when income from the underlying securities is modest. Some funds also assess redemption fees for early withdrawals, potentially locking investors into positions for extended periods.
  
  Careful tax planning considerations should accompany any investment in floating rate funds, as tax treatment can impact after-tax returns significantly.
• Leverage Amplifies Both Gains and Losses: Numerous floating rate funds employ leverage—borrowing money to purchase additional securities—to potentially enhance returns. While leverage can amplify gains when investments perform well, it equally magnifies losses when holdings decline in value or default.
  
  If a fund borrows to buy a loan that subsequently defaults, the impact is twofold: the investment loses value and the borrowed funds still require repayment. This leverage risk represents a critical consideration for conservative investors. Closed-end floating rate funds typically use more leverage than open-end funds.
• Credit Risk Considerations: Floating rate funds often invest in below-investment-grade securities with higher default risk. These bank loans and high-yield bonds carry credit ratings in the BB and B range, reflecting increased probability of payment difficulties compared to investment-grade debt.
  
  According to FINRA’s investor education resources, bonds and bond funds can be important components of diversified portfolios, offering capital preservation and income generation alongside varying degrees of risk.
  
  While floating rate structures address interest rate risk, they don’t eliminate credit risk. Comprehensive financial planning should account for the credit quality of any floating rate investments in your portfolio.
• Liquidity Constraints: Some floating rate funds restrict redemptions to specific windows—monthly, quarterly, or even annual periods. This limited liquidity can create challenges if you need to access funds unexpectedly. The lack of daily liquidity distinguishes these products from traditional mutual funds and requires careful consideration of your cash flow needs.

Floating Rate Funds in the Current Rate Environment (2025)

With the Federal Reserve transitioning from rate hikes to rate cuts beginning in late 2024, floating rate funds face a shifting landscape. As rates decline, the income from these funds typically decreases as the underlying securities’ coupon payments adjust downward. This makes the timing of investment crucial.

Investors considering floating rate funds in a rate-cutting environment should weigh several factors. While the funds may experience declining income, they still offer reduced interest rate sensitivity compared to fixed-rate alternatives. Unlike fixed rate bonds that may increase in price when rates fall, floating rate investments generally maintain stable prices but offer reduced income.

The current environment presents both challenges and opportunities. For investors who entered positions during the high-rate period of 2022-2024, floating rate funds provided attractive yields. However, new investors in 2025 should consider whether the trade-offs align with their income needs and rate expectations over their investment horizon.

When Should You Consider Floating Rate Funds?

Several scenarios may warrant consideration of floating rate investments as part of a diversified portfolio:

1. When interest rates are low but expected to rise, floating rate funds offer the potential to capture increasing income without the price depreciation associated with fixed rate bonds. This positioning can be particularly relevant during the early stages of Federal Reserve tightening cycles.
2. Investors dissatisfied with minimal yields on cash and short-term fixed income might find floating rate funds appealing. These products typically offer yield premiums above money market rates while maintaining relatively low duration.
3. For those concerned about inflation risk, the variable nature of floating rate income provides some protection against rising prices. As inflation pressures push interest rates higher, floating rate securities can adjust to reflect these new conditions.

However, floating rate funds should be viewed as tactical allocations rather than core bond holdings. They work alongside, not as replacements for, diversified fixed income portfolios. Before investing, evaluate your risk tolerance, income needs, time horizon, and overall investment strategy.

Ideal Investor Profiles for Floating Rate Funds

Understanding whether floating rate funds align with your investment objectives requires honest assessment of your financial situation and goals.

1. Income-Focused Investors in Rising Rate Environments

Retirees or pre-retirees seeking higher yields than traditional bonds while managing rate risk may find floating rate funds appropriate. These investors typically have moderate risk tolerance and prioritize income stability over capital appreciation. However, they must accept that income will fluctuate with market rates.

2. Conservative Investors Concerned About Rate Volatility

Investors wanting fixed income exposure with reduced duration risk can use floating rate funds to mitigate interest rate sensitivity. This profile includes those who believe rates may rise but want to maintain some bond allocation for diversification and stability.

3. Portfolio Diversifiers

Sophisticated investors looking for low-correlation assets to complement traditional stock and bond allocations may allocate 5-15% of their fixed income sleeve to floating rate funds. These investors understand the credit risks involved and actively monitor their allocations.

4. Who Should Avoid Floating Rate Funds

Floating rate funds are generally not appropriate for risk-averse investors requiring capital preservation, those needing guaranteed daily liquidity, investors in falling rate environments seeking capital appreciation, or those unable to tolerate potential credit losses. Additionally, investors who don’t understand the complexity of floating rate structures should seek guidance before investing.

How to Evaluate Floating Rate Funds for Your Portfolio

When considering floating rate funds, examine several key factors:

• Review the fund’s expense ratio and compare it to alternatives. High fees can significantly erode returns over time, particularly in modest income environments. Understand any redemption restrictions or penalties that might limit your flexibility.
• Assess the credit quality of the fund’s holdings. Higher-quality portfolios offer more stability but typically lower yields, while lower-rated holdings provide higher income potential with increased default risk. Your comfort with credit risk should align with the fund’s profile. Examine what percentage of holdings are rated B or below, and compare this to historical norms.
• Understand whether the fund uses leverage and to what degree. Leverage can enhance returns but amplifies risks. Conservative investors may prefer funds that avoid leverage entirely or use it sparingly.
• Consider the fund’s liquidity profile and redemption terms. Daily liquidity offers maximum flexibility, while quarterly or annual redemption windows require careful planning to align with your cash flow needs.
• Examine how the fund’s current yield compares to alternatives. Remember that yield tells only part of the story—total return considerations should include potential price movements and credit risks. Evaluate the fund manager’s track record in credit selection and their experience navigating different rate environments.