Floating-Rate Funds Offer Higher Yields…and Higher Risks

When interest rates are low, many fixed-income investors search for creative ways to obtain higher yield, leading many of them to floating-rate mutual funds.

Floating-rate loans are variable-interest-rate loans made by financial institutions to companies that have low credit quality. The loans are said to have “floating” interest rates because the interest rate paid on them adjusts periodically, usually every 30 to 90 days, based on changes in widely accepted reference rates and a predetermined premium over the reference rate.

A floating-rate fund buys those loans and gives investors the opportunity to share in the potential earnings. The potential benefit to investors may overcome the potential interest-rate risk – the risk that your investments will yield less when interest rates are low. That’s because floating-rate fund loans generally pay interest rates that are higher than those of many other fixed-income investments, such as money market funds and U.S. Treasuries. Additionally, floating-rate funds may offer the potential for diversification: They usually have low correlations to other major asset classes.

As with most investments, there are other risks to investing in floating-rate loans. Because these generally invest in the debt of borrowers with low-credit quality, floating-rate funds should be considered somewhat risky. And floating-rate funds may not have stable net asset values, which makes some investors uncomfortable.

If you’re comfortable with high-yield risks, however, a floating-rate fund may be appealing in today’s low-interest-rate environment. Be sure to consult your advisor to determine if this is an option for you.

Are Your Global Investments Currency-Hedged?

As world economies become increasingly connected, more and more investors are investing abroad, but doing so raises a new risk. International investments are purchased in international currencies, and that can create what’s commonly called “currency risk.”

Currency risk stems from the change in the price of one currency relative to another. To illustrate, let’s say you buy $10,000 worth of shares in a Japanese company. To do so, you’ll need to convert your U.S. dollars to Japanese yen. At the time, one yen equals two dollars, so you end up with 5,000 yen invested in shares of the Japanese company.

Now, let’s say a few months later you want to sell your shares, which have neither increased nor decreased in market price. To do so, you’ll have to convert them back into U.S. dollars. If the exchange rate stays the same – one yen equals two dollars – you’ll get $10,000 back. But, let’s say the exchange rate changes so that one yen equals one dollar. In this case, your investment, for which you paid $10,000, will be worth only $5,000. The share value didn’t change; the exchange rate did.

When you invest in international mutual funds that follow indices which measure global equity performance, such as the MSCI EAFE, you take on currency risk. This may be beneficial during periods of a weakening U.S. dollar, but if the U.S. dollar strengthens against the international currency you’re invested in, you could lose money.

Currency-hedged investment

You don’t have to take on currency risk, however. If you prefer to avoid it, you can seek out a currency-hedged investment.

Investorwords.com  defines currency hedging as “a particular hedging strategy used to reduce risks in the foreign exchange market.” It’s fairly complicated, but professional fund managers do it well. So, if you’d like to invest internationally but avoid currency risk, ask your advisor about currency-hedged products.