What Is a Floating Rate Fund?
Let me explain what a floating rate fund is: it's a fund that puts money into financial instruments paying a variable or floating interest rate. You can find these as mutual funds or ETFs, and they focus on bonds and debt where interest payments change with an underlying interest rate. Unlike fixed-rate investments that give you stable, predictable income, these can lag when rates rise because their returns stay the same.
These funds are designed to give you flexible interest income when rates are going up. That's why they've become more popular as people try to increase their portfolio yields.
Key Takeaways
Remember, a floating rate fund invests in instruments with variable rates, including bonds and debt that adjust with interest levels. They can hold corporate bonds or bank loans to companies, sometimes repackaged for investors, but watch out for default risk. While they offer better yields when rates rise, you need to balance that against the risks and check the fund's holdings carefully.
How a Floating Rate Fund Works
There's no single formula for calculating a floating rate fund, but they can include various investments. Think preferred stock, corporate bonds, and loans maturing from one month to five years, or even corporate loans and mortgages.
Floating rate loans are what banks give to companies, often bundled into funds for you to invest in. They're like mortgage-backed securities, where packaged mortgages provide a return from combined rates.
These loans count as senior debt, so they get first claim on a company's assets if there's a default. But 'senior' just means priority in repayment, not high credit quality.
Floating rate funds might also include floating rate bonds, where interest adjusts over time, often based on the fed funds rate set by the Federal Reserve, plus a fixed spread. When rates go up, so does your return.
What Does a Floating Rate Fund Tell You?
The main advantage is lower sensitivity to interest rate changes compared to fixed-rate options. These funds attract you when rates are rising because they pay higher interest or coupons.
They're a good fit for the fixed income or conservative part of your portfolio. They hold various floating rate debts like bonds and loans, managed with goals around credit quality and duration. The rates adjust based on defined levels or parameters, so they're less exposed to duration risk—that's the risk of missing higher market rates while stuck in a fixed investment.
Portfolio managers handle the income from underlying investments and distribute it to you, including income and capital gains, usually monthly but sometimes quarterly or annually.
Beyond low interest rate sensitivity and reflecting current rates, these funds help you diversify fixed-income holdings, since most investors have mainly fixed-rate bonds. They also let you get a diversified portfolio at a low entry cost, instead of buying individual instruments expensively.
When looking at one, make sure the securities match your risk tolerance. These funds vary in risk across credit qualities, with higher-risk, lower-quality ones offering potential for bigger returns but more danger.
Examples of Floating Rate Fund Investments
Floating rate funds can include any floating rate instrument, mostly bonds or loans. Here are two common ones.
Specific Examples
- The iShares Floating Rate Bond ETF (FLOT): This tracks the Barclays Capital US Floating Rate Note <5 Years Index, with notes maturing under five years and rates based on one to three-month LIBOR plus a spread. LIBOR is the rate banks lend to each other short-term, calculated daily from bank estimates. It holds investment-grade notes from places like Goldman Sachs, Inter-American Development Bank, and Morgan Stanley, with a 0.20% expense ratio, 1.89% 12-month yield, and over $5.79 billion in assets as of September 2020.
- The iShares Short-Term Corporate Bond ETF (IGSB): This invests in investment-grade corporate bonds with one to three years left to maturity, featuring a 0.06% expense ratio, 2.62% 12-month yield, and $20.2 billion in assets.
The Difference Between Money Market Funds and Floating Rate Funds
A money market fund is a mutual fund investing in highly liquid, high-credit cash equivalents with short maturities under 13 months, offering high liquidity and low risk but typically lower rates than floating rate funds.
Floating rate funds have higher risk, as they can include below-investment-grade securities like loans, unlike the high-quality focus of money markets.
The Limitations of Using Floating Rate Funds
Credit risk is a key concern if you're chasing yield but wary of extra risk. When Treasury yields are low, these funds look better, but Treasuries are safer, backed by the U.S. government.
Holdings might include near-junk corporate bonds or risky loans. They yield more in rising rates, but you must assess risks and research holdings.
Other short-term bond funds invest mainly in Treasuries with fixed rates or lower yields. Weigh risks and returns before deciding.
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