Floating rate mutual funds: rewards and risks

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Floating rate mutual funds invest in bonds and other fixed income securities that have variable rather than fixed interest rates. When interest rates are low, fixed income investors look for creative, sometimes riskier, ways to earn additional income.

For this reason, floating rate mutual funds attract the attention of yield-hungry investors and mutual fund companies who love to feed them. Read on to learn more about variable rate mutual funds and some of the important things to consider before you take your first bite.

Key points to remember

  • A floating rate fund is a mutual fund that invests in financial instruments, such as bonds and bank loans, by paying a variable or floating rate of interest.
  • Most floating rate funds invest in relative short-term bonds, which means they have a relatively shorter duration than other fixed income mutual funds.
  • These funds are able to navigate with more agility in a changing interest rate environment and offer investors a unique layer of diversification.
  • Floating rate funds might have holdings that include corporate bonds that are close to junk status or loans that present a risk of default. Investors should assess the risk level of a fund’s portfolio before investing.

Floating rate funds

Floating rate mutual funds can be both open and closed. Buyers, beware: some floating rate funds allow you to buy shares on a daily basis but will only allow you to buy back your shares on a monthly or quarterly basis.

Floating rate funds typically invest at least 70-80% of their holdings in floating rate bank loans. The remaining 20-30% of the fund’s holdings are usually invested in items such as cash, high and low-quality bonds and derivatives. Many of these funds attempt to increase their returns by using financial leverage. You are more likely to see large amounts of leverage used in a closed floating rate fund than an open fund.

The returns offered by floating rate funds are generally somewhere between the returns of high quality bond funds and high yield bond funds. Each mutual fund is structured differently when it comes to the use of leverage, investment strategy, expenses, and the rules for buying and redeeming your stocks. As always, it’s important to read a mutual fund’s prospectus carefully before investing.

Variable rate bank loans 101

When investing in variable rate funds, it is important to understand the basics of variable rate loans. Variable rate loans are variable rate loans made by financial institutions to businesses generally considered to have low credit quality.

They are also called syndicated loans or senior bank loans. Borrowers take out these loans to raise capital for things like recapitalizations, debt refinancing, or to make acquisitions. Once the banks create the loans, they sell them to hedge funds, secured loan bonds (CLOs), and mutual funds.

Loans are called “variable rate” because the interest paid on loans adjusts periodically, usually every 30 to 90 days, based on widely accepted benchmark rate changes, such as the London Interbank Offered Rate (LIBOR ), plus a predetermined credit spread. on the benchmark rate. The size of the credit gap depends on factors such as the credit quality of the borrower, the value of the collateral securing the loan, and the covenants associated with the loan.

Variable rate loans are classified as senior debt and are generally secured by specific assets, such as inventory, receivables, or property of the borrower. The word “senior debt” is particularly important here. This means that loans are generally superior to bondholders, preferred stock holders, and common stock holders in the borrower’s capital structure.

Not all variable rate loans “float” all the time. Some of the loans may come from options, such as interest rate floors, which may affect the interest rate risk associated with holding the loan.

Main qualities of variable rate funds

Unwanted status and seniority

Because they typically 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 generated by the funds will be used to offset credit risk. Part of the credit risk associated with investing in low-credit quality corporate debt is offset by the “age” of the capital structure of a variable rate loan and the collateral that supports it.

Historically, the recovery rates for defaults on floating rate loans have been higher than those on high yield bonds, resulting in lower potential credit losses for investors. A diversified portfolio of floating rate loans should perform well when the economy recovers and credit spreads tighten.

Limited time

The net asset value (NAV) of a floating rate fund should be less sensitive to changes in short-term borrowing rates than other income-producing mutual funds, such as long-term bond funds. The term of a variable rate loan is about seven years, but the underlying interest rate of most loans will adjust every 30 to 90 days, depending on changes in the benchmark rate.

For this reason, the market value of a variable rate loan will be less sensitive to changes in short-term borrowing rates compared to most fixed rate investments. This makes floating rate funds attractive to income investors in times when the economy is recovering and short-term lending rates are expected to rise.

Diversification and 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, investment grade corporate bonds, and bonds. municipal.

However, price correlations between floating rate loans and other risky asset classes are known to converge during times of stress in financial markets. The variable rate loan market is a fairly untapped niche market that most investors do not have direct access to.

These less scrutinized markets may have their advantages. The less efficient the market, the more opportunity good fund managers have to generate higher risk-adjusted returns. For this reason, it is particularly important to check the investment manager’s performance history, seniority in the fund and experience of investing in alternative assets before investing in a floating rate fund.

The bottom line

Low interest rate environments can encourage investors to seek additional return without understanding the risk they are taking. The growing popularity of income-generating financial products, such as floating rate funds, makes it important for investors to familiarize themselves with the basics of alternative asset classes.

Floating rate funds can offer income investors diversification and some protection against interest rate risk. They can be an alternative (albeit riskier) way to add additional income to your underperforming portfolio. Just make sure you’re comfortable with their risks and don’t bite more than you can chew.


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