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An Investors Guide to Floating Rate Funds: Benefits and Considerations

Susan Kelly

Dec 12, 2023

Floating rate funds are mutual funds or ETFs that invest in financial products with shifting interest rates. These funds primarily invest in bonds and debt with variable interest rates. Floating-rate funds offer variable interest income, unlike fixed-rate investments that may lag with rising interest rates. As interest rates rise, investors seeking higher portfolio income find them appealing. A floating rate fund is popular with investors who want to maximize profits in volatile markets because they may hedge against interest rate risk.

Working of Floating Rate Funds

Floating rate funds invest in preferred stock, corporate bonds, and loans with maturities from one month to five years. Banks provide significant corporate loans. These loans can be bundled into a fund to give investors a diverse portfolio. Floating-rate loans give a changeable revenue stream dependent on numerous interest rates in the fund, like mortgage-backed securities.

Senior debt, such as floating rate loans, has a more significant claim on a company's assets in the event of failure, highlighting its repayment priority. Notably, "senior" refers to asset claims order, not credit quality. The funds may include floating-rate bonds and financial securities with flexible interest rates.

The Federal Reserve Bank's fed funds rate can affect these bonds' interest rates. A floating rate bond's return is usually the fed funds rate plus a spread. Floating-rate bond fund returns grow with interest rates, giving investors a dynamic income stream that adjusts to interest rate movements.

Role of Floating Rate Funds

An investor's portfolio needs a variable rate fund for its distinct benefits in fixed income and conservative investing. Its reduced interest rate sensitivity compared to fixed-rate instruments is its main benefit. This makes variable-rate funds appealing during rising interest rates.

Investors choose variable-rate funds because they pay more interest or coupons as interest rates rise. The fund's flexibility to adapt dividends to interest rate fluctuations reduces duration risk for fixed-income investors who may lose out on higher yields. Floating rate debt like bonds and loans gives the fund flexibility. Actively managed floating-rate bond funds allow portfolio managers to target credit quality and duration. Adjustable rates on the fund's investments help manage duration risk.

The variable rate fund's investment income is regularly distributed to shareholders. These income and capital gain payouts attract income-seeking investors to the fund. These monthly, quarterly, semi-annual, or yearly distributions make fund income predictable. Fixed-income investors can diversify with floating-rate funds beyond interest rate advantages. Since fixed-rate bonds dominate typical bond portfolios, this is good.

A variable rate fund also offers a more accessible entry point to a diversified bond or loan portfolio than investing in individual assets at more significant dollar amounts. Since variable rate funds span a variety of credit quality risk levels, investors must do their due diligence to match their risk tolerance to the fund's risk profile. Better-risk investments can provide better returns, but investors must balance their financial goals and risk appetite.

Limitations of Using Floating Rate Funds

If you're an investor looking for larger yields without sacrificing safety, you might be concerned about the credit risk of variable-rate funds. Investors should thoroughly assess the credit risks associated with variable rate funds before putting their money into them, even if such funds may seem appealing.

In contrast, U.S. Treasury rates are low because of the possibility of higher returns in a rising rate environment. A Floating rate fund may contain assets like loans with default risk or corporate bonds close to junk status, in contrast to the government-backed and exceedingly safe U.S. Treasuries.

Because of the trade-off between increasing exposure to credit risk and pursuing higher returns in variable-rate funds, investors must carefully investigate and comprehend the particular holdings inside these funds. Investors must assess and balance these risks to make well-informed decisions that align with their risk tolerance and financial goals.

Examples of Floating Rate Funds

There are two primary examples of best floating rate funds:

The iShares Floating Rate Bond ETF (FLOT)

Common characteristics are shown by floating rate funds such as the iShares Floating Rate Bond ETF (FLOT). Floating Rate Note ~5 Years Index from Barclays Capital is mimicked by FLOT regarding price and yield performance. Any floating-rate note under five years old is included in this index. The coupon rates on these notes are usually the one- to three-month LIBOR rate plus a spread.

LIBOR, the London Interbank Offered Rate, is a global benchmark for short-term interest rates, representing the average rate large banks lend to each other. LIBOR in the coupon computation makes the fund responsive to short-term interest rate movements. The investment-grade floating rate notes from Inter-American Development Bank, Goldman Sachs Group, Inc., and Morgan Stanley comprise FLOT's portfolio. This focus on investment-grade securities shows a commitment to fund credit quality.

FLOT offers investors a cost-effective variable rate instrument exposure with a 0.20% expense ratio and a 1.89% 12-month yield (as of September 2020). The fund's $5.79 trillion assets under management demonstrate its popularity and investor confidence in its ability to understand short-term interest rates and credit quality to provide competitive returns.

The iShares Short-Term Corporate Bond ETF (IGSB)

The iShares Short-Term Corporate Bond ETF (IGSB), managed by BlackRock subsidiary iShares, exposes investors to investment-grade corporate bonds with maturities of one to three years. Short-term corporate debt allows IGSB to balance corporate bond yields with lower interest rate risk. The fund provides affordable access to a diverse portfolio of high-quality corporate bonds at 0.06%. IGSB's 12-month yield is 2.62%, indicating bond income. Its $20.2 billion assets under management demonstrate its appeal among corporate bond investors seeking return and risk.

Money Market Funds Vs. Floating Rate Funds

The risk-return trade-off is the most crucial difference between the money market and fixed-rate funds. Safe and easy to get money from, money market funds give a modest return. Fixed-rate funds, on the other hand, may have better profits but more risk because they invest in lower-rated stocks. These funds have different levels of risk and return, so buyers need to consider how much risk they are willing to take and their investment goals.

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