It’s important to remember that eliminating one type of risk almost always results in assuming another when it comes to investing. There are no returns without some degree of risk taking. Floating rate bond funds are a great example of risk elimination actually being a risk trade.
Floating rate bond funds significantly reduce one of the biggest worries of fixed income investors, interest rate risk. It’s pretty commonly known that when interest rates go up, bond prices go down. Bond rates and prices are negatively correlated. Floating rate bond funds differ from traditional bond funds because their interest rates aren’t fixed. They’re periodically adjusted based on a floating reference point, such as LIBOR or the Fed funds rate plus a built in spread. It’s typical to see these rates adjust to reflect changes every 30-90 days. Since their rates adjust to current yield conditions, their prices are not affected in the same way most bond funds are when rates rise.
A bond fund with little to no interest rate risk? Sounds too good to be true!
Let’s return to the concept of there being no returns without some degree of risk taking. What’s the catch with floating rate bond funds? In return for muted interest rate risk, these funds assume far more credit risk. Credit risk refers to the possibility that the loans making up the bond fund will not be repaid in a timely fashion (or at all).
Floating rate bond funds are notorious for serving as a source of financing for companies with poor credit. Think of smaller or midsize businesses whose credit is not good enough to issue their own bonds. This means that the loans held in floating rate funds are significantly more likely to default than those held in higher quality fixed income products. In fact, returns on floating rate funds are most highly correlated to high yield (junk) bonds.
If you’re relying on a bond allocation to lower your portfolio’s overall volatility, you may want to think twice about investing in floating rate bond funds. When credit spreads widen, these funds are at a higher default risk. This is likely to be poor timing for your bond investments to become riskier. According to Morningstar, in 2008 the average bank-loan fund lost 30% while the average intermediate term bond fund lost 4.7%. This all occurred while the S&P 500 index dropped by over 40%. If your reason for owning bonds is to diversify and have a lower overall portfolio volatility, floating rate bond funds failed pretty miserably at providing that in the last real crisis we saw.
Many investors have misused these funds in the last few years as a way to express their prediction on the direction of interest rates. Just look back to the 12 months preceding June 30, 2013 for an example: Assets in floating rate bond funds increased by more than 70% seeing inflows of $45 billion. Those numbers include the infamous taper tantrum. We’re still waiting on the great rising rate environment, and I’m not smart enough to predict when we’ll see it. If somebody knows exactly when and by how much rates will rise…by all means, take advantage and pile into floating rate bond funds for their decreased interest rate risk. Just make sure to know when rates will stop rising too so you can time you exit from them.
Investors would do well to remember that they’re always trading one type of risk for another when it comes to investing. In the case of floating rate bond funds, the trade is accepting higher credit risk for lower interest rate risk.