Floating-Rate Bond Funds May Not Be All They Are Cracked Up To Be


Investors need to be cautious when considering floating-rate bond funds. Such funds are attractive to investors because of their relatively high-yields and of their inflation-protection based on the fact that they are floating rate. With inflation running at 2.3 percent, and 10-year U.S. Treasuries paying 0.6 percent less than that, floating rate funds paying an average of 6 percent are popular. As a result, investors have bought $1.8 billion of floating rate funds so far this year compared with stock fund outflows of $3 billion this year and $94 billion last year. “A Risky Yield Play,” by Jonnelle Marte, Wall Street Journal.

Notwithstanding the foregoing, floating rate funds have significant risks and investors must be aware of the downside. The increased demand for floating rate bonds has the effect of driving down yields. For example, during the credit crunch triple-C-rated companies paid as much as 47 percent for loans, but today that is down to 14 percent. Thus most of the returns have already been made.

Not so obvious is the fact that higher demand also results in looser restrictions for borrowers. These so-called “covenant-lite” loans, which have more relaxed repayment terms that are good for high-risk borrowers but bad for investors, now comprise 20 percent of the market ? near the peak of 25 percent in 2007, according to the article.

Investors should be skeptical of the credit quality of floating rate loans. If the economy worsens, investors could experience significant losses.

Page Perry is an Atlanta-based law firm with over 170 years of collective experience maintaining integrity in the investment markets and protecting investor rights.