Floating-rate funds are unique among fixed-income vehicles, giving investors the potential to benefit from—rather than be hurt by—rising interest rates. They hold lower-quality corporate loans whose interest payments can reset every three months or so, enabling the funds' yields to ratchet up if short-term interest rates rise—unlike conventional bonds, which go down in value when rates go up.
So what is the problem? Floating-rate funds might not be quite as buoyant as investors expect.
The income generated by bank loans has long been based on Libor, or the London Interbank Offered Rate, a standard measure of what banks charge one another to borrow. This week, the three-month Libor rate was below 0.25%, near all-time lows.
But about two years ago, bank loans began to include "Libor floors," or minimum levels at which their income payments begin ratcheting upward if interest rates rise. According to Robert Polenberg of Standard & Poor's Leveraged Commentary & Data, 40% of existing bank loans have Libor floors, with the level averaging 1.59%. Virtually 100% of newly issued loans, says Mr. Polenberg, include them.
While this feature ensures a minimum yield, it also acts as an anchor. To see why, consider the $3 billion bank loan raised last month for Chrysler Group. Maturing in 2017, it pays 4.75% plus a 1.25% Libor floor. That means its current coupon, or income stream, is locked at 6% until short-term interest rates rise above 1.25%. The loan's coupon can be adjusted upward every 90 days, but that won't happen until Libor exceeds 1.25%—a full percentage point above where it stands today.
That feature makes newer bank loans more like conventional bonds. "The loan behaves like a fixed-rate instrument with a higher [sensitivity to interest rates] until Libor breaches the floor," says Gautam Kakodkar, a structured-credit analyst at Barclays Capital.
Thus an upward jolt in interest rates not only could leave floating-rate loans temporarily unable to float but might even knock their prices down—until Libor finally rises far enough.
"I don't think you would see a dramatic drop," says Robert Dial, manager of the $1.4 billion MainStay Floating Rate fund. "It's conceivable that the market might [fall] a point or two. But investors would probably say, 'In a month or two, I catch up."'
David Allison of Allison Investment Management in Columbia, S.C., points out that charts of past performance showing these funds performing well when rates went up are based on periods before Libor floors were common. Who knows how investors will react if loans that they expected to float higher with rising interest rates just sit there?
"I think a lot of retail investors might be expecting a more-rapid increase in income than the Libor floors may allow in the short term if interest rates rise," says Justin Gerbereux, co-manager of the $2 billion T. Rowe Price Institutional Floating Rate fund.
What these funds offer is a trade-off: You get generous current income but might not benefit fully from rising yields until interest rates rise a percentage point or more. Your protection against rising rates should still kick in, but only after they have shot up considerably.
Investors ought to care about the risk of larger interest-rate increases over longer periods of time, says Christine McConnell, manager of the $12.1 billion Fidelity Advisor Floating Rate High Income fund. "In that case you're still getting the floating-rate protection you ultimately want. It's not fine-tuned, but it's still there."
Investing in a floating-rate fund, then, is a bit like buying insurance with a high deductible: a perfectly sensible decision, so long as you realize you have protected yourself against large risks while exposing yourself to smaller ones.
Unfortunately, a yield that floats after interest rates rise a lot—but mightn't while they rise just a bit—probably isn't what many investors had in mind when they bought these funds.