Funds — diversified investment vehicles that derive their value from ownership of underlying assets in a given index or sector — are commonplace in the stock market. Money is needed for mortgages, large corporate transactions, and other bank loans. As a result, firms bunch these secured loans into investment-grade products, selling shares of the fund as if it were a publicly traded company.
In general, funds are relatively low-risk investments. Their assets are secured by the house behind the mortgage or assets of the company that accepted the loan. They’re also a form of fixed-income security, providing investors with regular payments of predetermined amounts of money on predetermined dates.
However, if you’ve done any research in the world of investing, you’re aware that low risk generally comes with low returns. As such, most funds don’t provide the returns that investors would expect from an investment in an individual stock. Nonetheless, they are a great way to diversify your investment portfolio in order to balance risk.
While most funds are low risk, low reward, there is an exception to the rule; that exception is known as the floating rate fund.
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What Are Floating Rate Funds?
Floating rate funds — also known as prime rate funds, bank loan funds, and floating rate mutual funds — break all the rules of traditional investment-grade funds. In general traditional funds provide a lower level of risk, stable income, and a relatively low potential return. Floating rate funds are the exact opposite.
Floating rate funds are essentially bonds with a variable coupon rate, or interest rate. Through floating rate funds, variable interest rate loans are given to companies. However, rather than the traditional fixed rate you would experience when lending money to a company through bonds, the interest rate paid to the lender — the investor — changes as the prime rate changes.
With floating rate funds, investors are paid a total interest rate that’s composed of the national Federal Reserve’s interest rate, or Fed funds rate, plus a spread — additional interest paid over the current Fed funds rate.
In general, floating rate funds are high-risk loans offered to tattered companies. The state of financial unrest ultimately determines the spread the floating rate fund will offer above the Fed funds rate. So, while all floating rate funds are higher-risk investments than traditional bonds, they will come with varying levels of risk and potential reward depending on the credit risk of the borrowing company.
When investing in floating rate funds, investors look for a high yield. However, it’s important to keep in mind that financially stable companies have several options and will rarely consider a variable interest rate. Companies that take part in floating rate funds are generally struggling, teetering on a figurative tightrope. So before investing in these vehicles, it’s important to understand what you’re getting into and do a great deal of research to make sure the companies you loan money to are not in immediate danger of bankruptcy.
History of Floating Rate Funds
Floating rate funds are a relatively new investment vehicle. They were first introduced in Europe, and found their way to the United States in 1974. In the first year of U.S. availability of floating rate funds, $1.3 billion in value of these investments were sold.
From there, floating rate funds gained serious steam in the U.S. Over the next decade, the market surrounding these funds ballooned, with major mutual funds adding these new investment vehicles to their repertoire of product offerings.
Unfortunately, as the turn of the century came into swing, several floating rate funds realized sudden and unexpected declines in value. The sudden drop was caused by a mandatory third-party pricing rule put in place by the U.S. government on all floating rate funds or prime rate funds. Prior to the regulatory changes, companies were using various methods of loan valuation, oftentimes showing loan values to be higher than they actually were.
In order to make sure investors were receiving accurate information with regard to the floating rate funds they buy, the Securities and Exchange Commission (SEC) stepped in and standardized the valuation process under U.S. securities laws.
As a result of this new standardized method of valuation, share prices of floating rate funds began to drop dramatically. Today, floating rate funds are regarded as relatively high-risk derivatives, yet they have regained much of their popularity that was lost as a result of the dramatic declines at the turn of the century.
Advantages of Floating Rate Funds
Floating rate funds have become popular for several compelling reasons. Some of the biggest benefits involved in investing in floating rate funds include:
- Higher Yield. Floating rate funds are known for providing a far higher yield than treasury bonds, CDs, and other safe-haven investments, making them an attractive choice for investors who are looking for safer options than high-risk stocks, but better returns than traditional safe-haven investments.
- Price Stability. Floating rate funds don’t experience much volatility. Because the value of the assets that secure these funds doesn’t tend to change much, the prices of floating rate funds remain relatively stable.
- Senior Secured Loan Investments. Floating rate funds are backed by senior secured corporate loans. This ultimately reduces the level of risk associated with the investment, because senior loans are first in line to be paid back in the event of a liquidity crisis that leads to bankruptcy.
- Benefit From Improving Economic Conditions. When economic conditions improve, interest rates rise. When the federal funds rate rises, the return on investment realized by those who invest in floating rate funds will rise as well.
- Diversification. As is the case with most mutual funds and exchange-traded funds (ETFs), heavy diversification seems to be at the center of most floating rate funds. This diversification protects your portfolio from significant losses should one of the holdings within the fund experience a plunge in value.
Disadvantages of Floating Rate Funds
As with any investment vehicle, floating rate funds may be a great fit for some investors, but there are some disadvantages that will turn many investors off. Some of the most crucial disadvantages to understand include:
- High Expense Ratios. When compared to traditional corporate bonds and municipal bonds, floating rate funds have relatively high expense ratios. Investments that come with high expense ratios ultimately deliver lower total returns due to the costs associated with the investment.
- Interest Rate Risk. When economic conditions are positive, interest rates rise. However, when economic conditions are negative, interest rates fall. The Federal Reserve often reduces interest rates in an attempt to spur lending and economic growth, but low interest rates mean lower returns for floating rate fund investors. So, although many see floating rate funds as a sort of safe-haven investment, they are anything but — they will generally fall during tough economic times.
- Liquidity Risk. Floating rate funds don’t experience high levels of liquidity. In fact, you may only be able to redeem your funds once per month or once per quarter. Many floating rate funds also require investors to stay put for the first year. Therefore, if you need quick access to your money, floating rate funds are not the way to go.
- Additional Redemption Fees. This is another disadvantage that surrounds liquidity. With many floating rate funds, if you withdraw any money in the first three years, you may have to pay additional redemption fees, only increasing the expense ratio associated with the investment.
A Warning From FINRA
The Financial Industry Regulatory Authority (FINRA) is charged with protecting investors from investments that come with a high risk of loss. Unfortunately for proponents of floating rate funds, they have often found their way onto FINRA’s radar in the past.
In fact, in a 2011 warning to investors, FINRA offered the following about floating rate funds:
“Unlike traditional fixed-income bonds, the market for floating-rate loans is largely unregulated and the loans do not trade on an organized exchange, making them relatively illiquid and difficult to value. Funds that invest in floating-rate loans may be marketed as products that are less vulnerable to interest rate fluctuations and offer inflation protection, when in fact the underlying loans held in the fund are subject to significant credit, valuation and liquidity risk.”
Any time FINRA makes it a point to warn investors about the risks associated with an investment vehicle, it’s important to do your research before diving into that vehicle. According to various warnings from FINRA, floating rate funds and other debt securities come with high levels of risk. Moreover, the regulatory authority has consistently pointed out that these complex financial instruments are generally not the best option for inexperienced investors.
Who Should Invest in Floating Rate Funds?
Some articles you read online will tell you that floating rate funds have a place in any investing portfolio, with some even characterizing them as suitable choices for a fixed-income or conservative portfolio.
Considering the serious warnings provided by FINRA, that’s not necessarily the case. In fact, the warnings from the regulatory authority suggest that many investors should seriously reconsider their allocation strategy if they are interested in buying floating rate funds.
So, who should invest in floating rate funds?
Instead of focusing on who should invest in floating rate funds, it’s easier to outline who shouldn’t. If you fall into any of the following groups, floating rate funds probably shouldn’t be part of your asset allocation strategy:
- Novice Investors. Novice investors are just learning the ropes in the stock market and are better served purchasing more traditional investment vehicles like common stock, bonds, ETFs, and mutual funds. Floating rate funds are complex financial instruments that come with confusing fee structures that the novice will generally have a difficult time completely understanding. So, if you’re new to investing, floating rate funds aren’t right for you.
- Risk-Averse Investors. Floating rate funds are generally backed by high-risk loans. Although these are senior secured loans that are paid back prior to common stockholders and other investors, the loans are given to companies with a high probability of default. As a result, the perception of low risk is a false one, and risk-averse investors should steer clear of floating rate funds.
- Investors Looking for Momentum. A big allure of the stock market is the fact that big gains can happen quickly. If you’re looking for high-momentum upward movement, however, floating rate funds aren’t where you’ll find it.
How Much of Your Portfolio Should Be Invested in Floating Rate Funds?
So, how much should you invest in floating-rate funds? The likely answer is zero. The majority of investors can achieve their goals with far less risk. However, if you must have floating rate funds in your investment portfolio, it’s important to seriously limit your holdings in these financial instruments.
Sure, a high yield is always attractive, but with high yields come high levels of risk. It’s important to keep high-risk investments at a minimum within a solid asset allocation strategy.
A general rule of thumb is that you should never have more than 5% of your total investment portfolio value tied up in high-risk investments. So, if your portfolio’s value is $100,000, and you want 100% of your high-risk allocation to be in floating rate funds, you would invest no more than $5,000 into these financial products.
What to Look for in Floating Rate Funds
If you decide to start investing in floating rate funds, there are a few details that you should pay close attention to before risking your hard-earned money:
- Fees. One of the biggest issues with floating rate funds is that they tend to come with complex fee structures. Common fees include sales charges, management fees, and redemption fees. It’s important that you have a complete understanding of the fees you will be expected to pay, as well as any actions that could lead to additional fees, before you make an investment.
- Redemption Periods. Floating rate funds are not short-term investments. In most cases, they come with redemption fees associated with redeeming, or withdrawing, your money too early. Before making an investment, make sure that you understand the terms and how long your money will have to sit before you can liquidate without additional fees.
- Net Asset Value. The net asset value (NAV) of a floating rate fund — or any other fund for that matter — is the total value of all assets under management minus any debts and liabilities. For example, a floating rate fund may borrow money in order to give more loans and increase its assets. These borrowing activities may artificially inflate the value of the fund’s assets, so be sure to look at the fund’s NAV — which subtracts the corresponding debts — to get a clearer picture of the fund’s true value.
- Past Performance and Current Performance. Past performance and current performance should never be used as a sole indicator of future performance of any financial asset. However, past performance and current performance do provide an indication of what may happen in the future, and investors should consider these data points when making their final investment decision.
- Interest Payments. Floating rate funds are income securities that provide investors with interest payments. Interest payments will be higher when credit ratings are lower and vice versa. Before making an investment, pay attention to how the interest rate you’ll be paid is structured and when those interest payments will be made.
- Economic and Market Conditions. Floating rate funds are a cyclical investment, meaning that their returns tend to ebb and flow with economic and market conditions. When economic and market conditions are positive, interest rates rise, leading to stronger returns. When economic and market conditions are negative, interest rates fall, leading to weaker returns. An investment in floating rate funds should only be made when you believe there is plenty of economic growth ahead.
Floating Rate Fund Examples
Several major mutual fund families offer funds that invest in senior secured loans. Some of the better-known floating rate funds include:
- Eaton Vance Floating-Rate & High Income Fund (EVFHX). This fund has closely mirrored the returns posted by its underlying benchmark index, the S&P Leveraged Loan Index. The fund has annual expenses of 1.04% and has averaged just below 4% returns per year after expenses over the past five years. The fund has a maximum 2.25% sales charge.
- Fidelity Advisor Floating Rate High Income Fund (FFRAX). This fund’s performance slightly lags behind the aforementioned funds in performance, but also has slightly lower fees, with an annual expense ratio of 1.03% and a maximum sales charge of 2.75%.
- Putnam Floating Rate Income Fund (PFLRX). This fund does not have as long a track record as the other funds listed here, but the one- and five-year returns are comparable to those of Eaton Vance and Invesco. This fund does have somewhat lower expenses as well, with a maximum sales charge of just 1% and annual fees of about 1% as well.
Floating rate funds are offered by brokers, financial planners, investment advisors, and banks, as well as directly from the fund companies. The minimum amount required to purchase a floating rate fund will vary from one fund family to another; some funds will allow a minimum initial purchase of $250, while others require a larger amount, such as $1,000. These thresholds are generally uniform for all funds within a given family.
Although the returns offered by floating rate funds are attractive to many investors, every rose has its thorns, and this particular rose is loaded with them. As the promise of higher yields increases the popularity of floating rate funds, more and more investors are learning that higher yields generally come with higher risk.
Floating rate funds have their place in some investment portfolios, but are not suitable for beginners, the risk averse, or investors looking for high levels of liquidity. With the complexity of the investments and their fee structures, risk of a borrower default, and liquidity and interest rate risks in mind, it’s generally best to avoid floating rate funds. If you do choose to invest in floating rate funds, be sure to do your research to get a full understanding of all fees and risks associated.