Are Floating-Rate Funds Too Risky?

floating-rate fundsFloating-rate funds provide higher yield income to investors by buying bank loans made to companies with low credit quality. I like to think of these bank notes as intermediate-term junk securities (loan maturities are about seven years). Yields are higher because of the greater credit risk, but the banks consider the risk of loss somewhat limited because they have priority over other bondholders in the event of default. The securities are “floating-rate” because the bank loans are variable-rate loans. Since fund yields rise as interest rates rise, many investors see these floating-rate funds as attractive income investments that can hedge against inflation.

But are there other risks that investors should be aware of? In July 2011, the Financial Industry Regulatory Authority (FINRA) issued an investor alert warning on floating-rate funds. Here are some things you need to be aware of if you are considering investing in these funds:

– Bank loans are traded over the counter, not on an exchange. Thus, they are less liquid than investment grade bonds, and determining appropriate valuations for individual loans is difficult.

– Many floating-rate funds limit your ability to withdraw your money. Minimum holding periods and redemption fees are common.

– Many floating-rate funds have high expense ratios.

– Some floating-rate funds are leveraged (i.e., they borrow money to purchase additional loans to get higher returns). For these funds, the consequences of loan defaults could be more severe since the cost of buying on margin has to be factored in.

In one of his articles (here), Larry Swedroe makes the case that floating-rate funds really have equity-like risks and behave more like stocks than Treasury bonds.

At the present time, I don’t like these funds for all of the reasons given above, and because it is still likely that low interest rates may persist for a while longer (remember that in August 2011 Bernanke promised low interest rates through mid-2013). In the future, after an inflation trend has been established, I may take another look at them, but right now, I still see significant downside risk to owning these funds. In my book, they are not smart investments for income.