Floating rate funds are funds that focus on investments paying variable rates. Typically these investments are bonds and other debt-related investments.
Taking a step back: Just like a mortgage can be fixed rate or adjustable rate, so too can other debt. Unlike fixed income investments—bonds that pay a fixed rate of interest—floating rate investments pay interest at a floating rate.
Often, these products are corporate bonds or individual loans issued by banks that are securitized (turned into tradable investments). For instance, mortgage-backed securities might have a floating rate of interest.
How floating rate funds compare to fixed income
Fixed-rate investments have a predictable and stable income compared to floating rate funds. However, while interest payments are fixed on these investments, the price of the bonds may fluctuate on the secondary market.
With floating rate funds, the interest payments may increase as market rates increase. That flexibility creates several positives for investors. For instance, investors chasing yield might favor floating rate products, and floating rate funds, over fixed income.
6 Benefits and Drawbacks to Floating Rate Loans
Floating rate funds are often considered superior to other bonds types because of the perks they offer investors who are willing to take a risk to amplify their total returns. Here are __ pros and cons of floating rate funds compared to fixed income investments.
Pro: Different response to volatile markets.
The value of a bond funds comes from both the interest payment and the price of the bond (in other words, its total return). With floating rate bonds, their total return tends to be less sensitive to changes in short-term borrowing rates than traditional long-term bond funds.
When the Fed is hiking rates or the economy is recovering, floating rate funds may be more attractive to investors than fixed income alternatives. Potentially lower volatility in certain market conditions can be a pro.
Pro: Diversification benefits.
The unique structure of most floating rate funds means they often have low correlations to popular asset classes, including equity and fixed income funds. These funds are also less commonly traded meaning they may present an opportunity for investors and advisors willing to do their due diligence. Using a floating rate fund can help mitigate some of the default risk associated with individual products.
Pro: Potentially higher yield.
Floating rate funds may pay yields as much as 2% higher than fixed income alternatives. For investors focused on the income their portfolio produces (versus total return) this may seem like a positive. However, yield on floating rate investments can also fall significantly with markets, so anyone relying on investment income to pay their living expenses should exercise caution when building floating rate funds into their portfolio.
Con: Higher fees.
Many floating rate funds charge a higher annual expense ratio than standard bond funds. That expense ratio can eat into potential returns, including interest payments. These funds may also come with a sales charge that is assessed for any redemption made within a certain period of time after purchase. This period can be anywhere from one to three years, making the expense ratio crucial to determining if fixed-income or floating rate loans is better for your portfolio. Be sure to carefully read the prospectus associated with any floating rate fund before investing.
Con: Leverage can impact returns.
Many floating rate funds use leverage in their portfolios. This means that they borrow money to purchase additional loans to achieve a potentially higher return. While leverage may amplify returns, it can also amplify losses. If a fund borrows money to purchase a loan that defaults, for example, this investment can have a significant negative impact—not only does the investment lose money, the fund must also back the money it borrowed to buy thee defaulted loan.
Con: Redemption can be challenging.
Some floating rate funds restrict when investors can recover their shares, for instance they may only have one window per month or quarter. Some may specify that you can’t withdraw money or redeem shares for a full year. If you are counting on your investments to maintain your finances, the lack of liquidity can be a significant drawback.
Investing in floating rate funds
Before you invest in a floating rate fund, ask the following questions:
- Are interest rates low?
- Have interest rates fallen quickly in a short period of time?
- Are interest rates expected to rise?
- Are you dissatisfied with low short-term rates?
- Are you concerned about inflation risk?
- Do you currently have a high level of disposable income?
- Do you have a high risk tolerance?
If you answered yes to any of these questions, you may want to talk to an experienced wealth manager about floating rate funds and whether they are good investments for you. If you have questions about floating rate funds and whether or not they may be right for you, contact us to set up a consultation.