Float Like Butterfly, Sting Like A Bee

2/27/2017


I'm sure many of you reading this headline remember who first said it — boxing great Muhammed Ali. Ali used the phrase to describe his fighting style, a mix of smoothness and sting.

I was reminded of Ali's quote when I began researching an investment vehicle receiving a fair amount of love — floating-rate funds. Morningstar estimates that more than $12 billion in net inflows poured into floating-rate funds in the fourth quarter, including more than $7 billion in December. The December inflows represented the fourth-highest of any fund/ETF category (stocks or bonds) tracked by Morningstar.

To understand the appeal of floating-rate funds (also called "senior-loan," "bank-loan," or "leveraged-loan" funds), you must understand the interplay between interest rates and typical bond funds. When interest rates rise, fixed-rate bonds decline in value. The relationship works in reverse as well.

Unlike traditional bond funds, which mostly hold bonds issued by corporations or governments, floating-rate funds typically consist of variable-rate loans made by financial institutions to companies with low credit quality. The interest paid on the loans adjusts periodically, usually every 30 to 90 days, based on changes in widely accepted reference interest rates, such as Libor. Floating interest payments make these funds especially attractive during periods of rising interest rates.

Before jumping on the floating-rate bandwagon, however, be aware that it is not all butterflies. These funds can sting during periods of falling interest rates or volatile equity markets. Here are at least four major risks associated with floating-rate securities:

Interest-rate risk — Floating-rate funds will typically underperform traditional bond funds when interest rates decline. And accurately predicting interest rates is difficult, even now, when many are confident about the direction of rates in the year ahead. While the 10-year Treasury note's yield climbed to 2.53% on Jan. 25 from 1.88% on Nov. 8, the rate has actually been falling in the last four weeks and is now at 2.43%. History shows the consensus is often wrong when it comes to predicting rates.

Credit risk — Most floating-rate funds carry high default risk. Because of their seniority to other debt and equity, recovery rates after defaults have been higher in floating-rate funds than in traditional high-yield bond funds. Still, investors should think of floating-rate funds in the same way they view junk-bond funds when it comes to risk profile.

Liquidity risk — This risk is associated with the ability to buy and sell securities quickly and efficiently. Floating-rate funds suffer from a couple forms of liquidity risk. For starters, the size of the market — roughly $116 billion — represents less than 4% of the entire taxable bond fund market. It is easier for buyers to disappear in thinner markets.

Diversification risk — Vanguard research shows returns of floating-rate funds are most closely correlated with high-yield bond funds and the stock market. In fact, floating-rate funds showed a negative correlation with a number of segments within the traditional bond market. Floating-rate funds are a poor choice to diversify a stock portfolio.

The bottom line: Floating-rate securities can add value in environments of rising interest rates. But that value can dissipate quickly if rates turn lower, making these funds more of a trading or tactical investment vehicle than a buy-and-hold bond investment. Floating-rate funds make the most sense as alternatives in the high-yield space of bond portfolios, and they also represent a nice diversifier for broad fixed-income portfolios.

The Forecasts does not recommend any floating-rate funds. However, Fidelity Floating Rate High Income Fund ($10; FFRHX) is worth a look for its lower expense ratio (0.71% versus peer-group average of 1.11%) and decent performance. The fund yields 3.9%.

If your goal is to reduce interest-rate sensitivity, consider a traditional short-term bond fund, which has higher credit quality than a floating-rate fund. A favorite short-term bond fund is the Vanguard Short-Term Corporate Bond ($80; VCSH) exchange-traded fund, which yields more than 2% and has an expense ratio of just 0.07%.  


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