“I have read articles about investing in stocks, bonds, CDs and mutual funds, but there isn’t much out there about high yield floating rate funds. What is your opinion of these (funds) for an investor who can’t afford much risk?” – Janette, Volusia

 

Floating-rate funds are just one of the alternative investments that have caught the eye of savers and conservative investors looking for higher yields and reduced principal fluctuations when overall interest rates are on the move. Typically, these funds invest in corporate debt with a “floating” rate of coupon interest. Unbeknownst to many investors, some of these funds invest in lower quality, higher risk debt in an attempt to increase investor returns. Those two facts (the risks taken by the funds and the confusion for some investors), however, aren’t lost on the regulators. As recently as July of 2011, the Financial Industry Regulatory Authority (FINRA) warned investors about “chasing returns in structured products, high-yield bonds and floating-rate loan funds.” I could not agree more with FINRA’s Vice President of Investor Education, Gerri Walsh, who said “Investors should never make an investing decision solely by looking at an investment’s return, whether past or projected. Higher returns come with higher risk. Investors should always look behind an investment’s yield, ensure that they understand how the investment works and carefully consider its fees and risks before investing.” Prompted by the large inflows into what it refers to as riskier investment products, FINRA issued an Investor Alert, entitled, “The Grass Isn’t Always Greener.” (Visit finra.org to access the Investor Alert in its entirety.)

 

Investor confusion, and understandable regulatory concerns, seem to stem from there being more than one type of “floating-rate” mutual fund / investment:

 

Floating-Rate Notes are short-term, investment grade bonds. That’s a mouthful, so let’s break it down: Bonds that mature in less than ten years are called “notes;”  “short-term” usually means five years or less to maturity, and “investment grade” is a measure of the credit quality of the bond issuer (for example, the Standard & Poors rating agency, considers BBB, or better, to be investment grade). These notes pay a floating rate coupon that adjusts as market interest rates change.

 

A mutual fund or exchange-trade fund (ETF) that invests in floating-rate notes might hold hundreds of such notes. For example, at the beginning of 2013, Blackrock’s iShares Floating Rate Note (ticker FLOT) had 256 individual notes and the average maturity was about 1.5 years.

 

Floating-rate notes may be attractive to investors who want to “shorten up” their overall portfolios. They can also be used to improve overall portfolio diversification as they don’t usually move in “lock step” with stocks and fixed rate bonds. They may also be a good choice when short-term rates are expected to rise (because the coupons earned on floating-rate notes adjust with interest rates). Despite the emphasis on investment grade (BBB or better) credit quality, floating-rate notes still have default risk. Look for mutual funds or ETFs with a large number of holdings to help reduce this risk.

Floating-Rate Bank Loans (also called “bank loans” or “leveraged loans”) are a type of variable-rate, senior secured debt issued by below-investment-grade companies (BB or lower on the Standard & Poors rating agency scale). “Variable-rate” means the loan has a floating-rate coupon. Because of the lower ratings, these companies have to pay a higher “variable-rate” interest rate. In this situation, “senior” doesn’t mean old, but, rather, paid first before other debt in the event of financial difficulties. “Secured” means that the bank loans are secured by collateral such as equipment, real estate, or receivables, which helps to insulate investors if the borrowing company defaults. These loans are typically arranged by commercial and investment banks, hence the “bank loan” name tag.

 

Floating-rate bank loans may be attractive to investors who want to achieve many of the same objectives as with floating-rate notes. However, and it is a big “however,” the bank loan version comes with the potential for greater investor returns and greater risk of loss. It goes without saying that a well-diversified ETF or mutual fund with hundreds of choices would be a prudent move (for example, the Invesco Floating Rate Fund, ticker AFRAX, had 586 holdings at the end of the second quarter in 2013).

 

Now, to your question, Janette . . . I would not recommend a floating-rate fund as your only investment. I also would not view floating-rate funds as a way to avoid risk. By definition, all mutual funds are securities. As such, they have risk of loss. The key questions for you, and other investors, are “how much risk should I take” and “is the investment right for me?” The answers will vary with each individual’s situation.

 

David D. Holland, a CERTIFIED FINANCIAL PLANNER™ practitioner, hosts a weekday radio show. He has also authored two books in his Confessions of a Financial Planner series. Holland offers investment advice through Holland Advisory Services, Inc., a registered investment adviser in Ormond Beach. He can be contacted at (386) 671-7526. Email your financial questions to info@DavidHolland.com.