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.