In addition to the search for incremental yield, concern regarding the potential for rising interest rates has led many investors to seek alternative ways to protect against a rise in interest rates without sacrificing yield. The dual concerns have led many investors to consider floating-rate bond funds (also known as bank loans).
How Rates Are Set
Because the coupon rate floats with the current market rate, floating-rate notes exhibit minimal price sensitivity to changes in interest rate levels. Thus, they offer some protection against unexpected inflation. The benefits of this instrument seem to blind investors to its drawbacks.
Trading Term Risk for Default Risk
Unfortunately, credit risk tends to show up at exactly the wrong time: when equities are getting hit as well. In other words, just when you require the bonds in your portfolio to provide shelter from the storm—as Treasuries typically do—the risks of corporate loans show up in the fixed income you’re holding and both your stocks and bonds are hit at the same time.
This is exactly what happened in 2008 when floating-rate funds averaged losses of 29%, underperforming the Barclays Capital U.S. Aggregate Bond Index by 34%—not exactly the safe haven that bonds are supposed to be. A second negative can be high costs. The average asset-weighted expense ratio for floating-rate mutual funds and ETFs is about 0.9%.
That means that even though your investment is not an equity investment, it will have a significant amount of equity-like risk. And the problem is that you’re not being appropriately compensated for that risk. The bank, for instance, may not be passing on the full credit spread, and the funds are taking a big cut of the spread in the form of their expense ratios. For example, the DWS Floating Rate Plus Fund (DFRAX), with $1.4 billion in assets as of January 28, 2016, carries a sales load of 2.75% and has an expense ratio of 1.06%.
The result is that investors are taking all of the credit risk without receiving anything near the market’s required return. What’s more, the “Plus” in the fund’s name could well apply to the amount of credit risk that investors are taking. The fund has a credit makeup of 3% BBB (the lowest investment grade), 26% BB (speculative), 62% B (very speculative) and 9% below B (extremely speculative), of which 5% is not even rated.
As another example, we’ll take a look at the PowerShares Senior Loan Portfolio ETF (BKLN), with $3.8 billion in assets. The good news is that the fund’s expense ratio is “just” 0.65%. Its credit quality is also somewhat better than DFRAX: 14% of its portfolio is BBB, 44% is BB, 29% is B and 11% is below B, with 5% of that unrated.
Equity Risk in Disguise
The authors of a February 2015 article, Floating-Rate Bonds Revisited: The New ’Old Maid?’, cite a Moody’s report that warns: “Bank loan mutual funds, and ETFs in particular, have a structural mismatch between the cash settlement of the assets they hold and their liabilities to fund investors. In stressed market conditions, redemptions typically increase, potentially leading to scenarios where funds would be unable to return cash from the proceeds of fund investments to their investors within the typical cash settlement period.” The report adds that settlement times for bank loans “typically range from 15 to 25 days.”
The authors point out that another problem for floating-rate funds is that commercial banks can no longer act as the liquidity providers they were in the past. They don’t have the capacity, not even on corporate and high-yield bonds.
The Bottom Line
The minimization of interest rate sensitivity causes some investors to make the mistake of thinking that floating-rate note funds are substitutes for money market accounts or other high-quality, short-term investments. However, they do entail significant credit risk.
Therefore, investors should view these funds as they would high-yield (junk) bond funds and not as an alternative to high-credit-quality bond holdings. Add the heightened liquidity risk to the equation and I’m led to conclude that these funds should be avoided.