The Pros and Cons of Floating Rate Funds

by Jason Jenkins

The Pros and Cons of Floating Rate Funds

Floating rate funds are closed-end mutual funds that seek to provide yields that match the prime rate. This attractive yield is often more than twice the federal funds rate and somewhat higher than the rate on five-year CDs.

In order to get these kinds of yields, prime-rate funds invest in floating-rate, secured corporate loans. These loans have been made by commercial banks and insurance companies to corporations with “iffy” financial statements. In addition to borrowing money from the banks or insurance companies, the corporations may also have borrowed money by issuing junk bonds.

What you might like about floating rate funds:

  1. Floating rate funds often have yields better than CDs and so-called “safe haven investments,” like Treasuries, by as much as 2%. This can be an important difference for investors just to beat inflation.
  2. The share prices of these funds tend to stay stable because they don’t invest in bonds. This means that the prices of the underlying securities in the fund portfolios won’t fluctuate in response to changes in interest rates like bonds do, as they’re floating rate instruments tied to current rates – thus an interest rate hedge.
  3. Although risky, floating rate funds are usually lower risk than stocks or high-yield junk funds. floating rate funds invest in senior secured loans, which are in the front of the line to be repaid in case of bankruptcy. Senior secured lenders will receive their money before any stock or bondholder, so the prospect recouping some money seems relatively high.
  4. Just like with traditional mutual funds, the diversification within the fund’s portfolio protects you against the ill effects of any single default.

The following may give you cause for concern:

  1. A lot of floating rate funds only allow redemptions once a month, or once per quarter, and in some cases you have to leave it in for the first year. This may be a problem for some people, but remember that the greater access to your money can translate into a slightly lower yield.
  2. There may be redemption fees if money is taken out in the first three years of the investment.
  3. Many floating rate funds also have high expense ratios relative to bond funds, which can cut into your profit.
  4. You probably want to know if your fund is leveraging the portfolio.
  5. When you borrow money to purchase additional loans to get that higher return, the possible loss on the flip side becomes exaggerated due to the loss due to default and the cost of buying on margin.

Something else to keep in mind

Last July, the Financial Industry Regulatory Authority (FINRA) issued an investor alert warning that floating rate funds achieve their yields by investing in bank loans, which carry higher risk of default than investment-grade bonds. They're also traded over the counter, as opposed to on an exchange, so they're less liquid. The total effect, says FINRA, is that investors may be chasing the promise of higher returns without fully understanding the higher risk involved in these funds.

So, this market is experiencing a little of the herd mentality.

Fund managers argue…

Those who manage floating rate funds agree that they're risky, but say the pros overshadow the cons. For one, they’re more conservative than high-yield bond funds, says Paul Massaro, the co-manager of the T. Rowe Price Floating Rate Fund (PRFRX), If an underlying issue defaults, the long-term recovery prospects are better than for other high-yield bonds, because banks have priority over other bondholders in the event of a default.

Scott Page, co-manager of the Eaton Vance Floating Rate Fund (EVBLX) says the securities are no less liquid than municipal bonds or mortgage-backed securities.

But when it’s all said and done, an investment of this complexity requires the necessary due diligence. And these are probably not a good idea until we see interest rates stabilize above their current miniscule levels.

Good Investing,

Jason Jenkins

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