What Are Floating-Rate Funds?
Floating-rate funds are a type of investment vehicle that typically invests in bank loans with adjustable interest rates. These loans are often tied to short-term rates such as the Secured Overnight Financing Rate (SOFR) or the London Interbank Offered Rate (LIBOR). The interest rates on these loans reset periodically, usually every 30 to 90 days, which means that as short-term interest rates rise, the interest rates paid on these loans also increase.
Unlike traditional fixed-rate bonds, floating-rate loans are categorized under the bank loan category. This distinction is crucial because it allows floating-rate funds to offer a different risk profile compared to traditional fixed-income investments. The periodic reset of coupon rates ensures that investors can benefit from rising interest rates without the long-term commitment of fixed-rate bonds.
Benefits in Rising Interest Rate Environments
One of the primary advantages of floating-rate funds is their ability to benefit from rising interest rates. As short-term interest rates increase, so do the interest rates paid on the loans within these funds. This translates into higher income for investors, making them an attractive option in an environment where interest rates are on the rise.
Another significant benefit is the minimal duration risk associated with floating-rate loans. Unlike fixed-rate bonds, which can see significant price declines when interest rates rise, floating-rate loans are less affected by changes in interest rates. For example, during a period of rising rates, the average bank loan fund might experience a decline of around 5.8%, compared to a 10.8% decline for core bond funds.
Diversification and Low Correlation
Floating-rate funds can also enhance the diversification of your fixed-income portfolio. These funds have a low correlation to investment-grade bonds and U.S. Treasuries, making them a valuable addition to a diversified investment strategy. By including floating-rate funds in your portfolio, you can reduce overall risk and increase potential returns.
Moreover, floating-rate funds can be used in combination with high-yield bonds to tactically reallocate core fixed-income holdings in anticipation of rising interest rates. This strategic allocation can help you navigate changing market conditions more effectively.
Risk Considerations
While floating-rate funds offer several benefits, they are not without risks. One of the primary concerns is the poor credit quality of the loans within these funds. Many of these loans are non-investment-grade and are issued to highly leveraged companies. This increases the potential for defaults if the economy deteriorates or enters a recession.
It’s also important to note that while the variable interest rates mitigate interest rate risk, they do not eliminate credit risk. Investors need to be aware of these risks and ensure that their overall portfolio is balanced accordingly.
Performance and Historical Data
Historically, floating-rate loans have outperformed traditional fixed-income investments during periods of rising interest rates. For instance, floating-rate loans have often outperformed high-yield bonds, investment-grade corporates, and even the Bloomberg Aggregate Index during such times.
Specific statistics show that floating-rate funds have provided stable returns even in volatile market conditions. This historical performance data underscores the potential of these funds to deliver consistent income in a rising interest rate environment.
Investment Considerations and Strategies
When incorporating floating-rate funds into your investment strategy, it’s crucial to understand the underlying benchmarks and reference rates such as LIBOR or SOFR. Some floating-rate securities may also include caps and floors, which can impact the potential returns for investors.
Timing is another critical factor. While it’s challenging to time markets perfectly, a consistent allocation to floating-rate loans can provide a stable source of income over the long term. It’s advisable to maintain a balanced approach rather than trying to time market fluctuations.
