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Floating Rate Fund: Definition, Example and Limitations

file Photo: Floating Rate Fund: Definition, Example and Limitations
file Photo: Floating Rate Fund: Definition, Example and Limitations file Photo: Floating Rate Fund: Definition, Example and Limitations

What Exactly Is a Floating Rate Fund?

A floating-rate fund invests in financial securities with variable or floating interest rates. A floating-rate fund, such as a mutual fund or ETF, invests in bonds and financial instruments with fluctuating interest rates. Fixed-rate investments often yield predictable income. Rising interest rates cause fixed-rate investments to lag behind the market due to set returns.

In a rising-rate environment, floating-rate funds provide investors with variable interest income. The popularity of floating-rate funds has increased as investors seek to improve their portfolio yield.

How a Floating Rate Fund Works

The formula for a variable-rate fund is unknown but can include many assets. Floating rate funds can hold preferred stock, corporate bonds, and one- to five-year loans. Floating-rate funds can have business and home loans.

Banks lend corporations floating-rate loans. Repackaged loans are occasionally included in investor funds. Like mortgage-backed securities, floating-rate loans are packaged mortgages that investors may purchase and earn a return on from the fund’s several mortgage rates.

Senior debt, such as floating-rate loans, has a more significant claim on a company’s assets in the event of failure. The term “senior” refers to the sequence of claiming a company’s assets to repay the loan if it defaulted, not creditworthiness.

Floating-rate funds can include floating-rate bonds, which change investor interest over time. Floating-rate bonds can be based on the Fed funds rate, determined by the Federal Reserve Bank. The variable-rate bond’s return is usually the fed funds rate plus a spread. The variable-rate bond fund returns climb with interest rates.

What do floating-rate funds tell you?

The primary benefit of a variable rate fund is its reduced interest rate sensitivity compared to a fixed payment rate or fixed bond coupon rate fund. Investors choose floating-rate funds when interest rates rise because they pay more interest or coupons.

Fixed-income or conservative portfolios benefit from investing in floating-rate funds. A floating-rate fund can hold bonds and loans with floating rates. Similar to credit funds, these funds have different goals. Credit quality and length might be targeted. The rates on floating-rate instruments in floating-rate funds adjust according to a defined interest rate level or set of criteria.

Duration risk is less critical for variable-rate funds. Duration risk refers to missing out on more excellent market rates due to rising interest rates when holding a fixed-income investment.

A variable-rate fund’s portfolio managers regularly distribute income from its investments to owners. Capital gains and income are distributed. Distributions might be paid monthly, quarterly, semi-annually, or yearly.

In addition to being less sensitive to interest rate swings and reflecting current rates, floating-rate funds allow investors to diversify fixed-income assets, as most investors hold mostly fixed-rate products. Investing in a variable-rate fund will enable investors to purchase a diversified bond or loan portfolio at a lower investment threshold than investing in individual derivatives.

Investors should ensure the securities match their risk tolerance when assessing a variable-rate fund. High-yield, low-credit-quality floating-rate funds incur more risks. Riskier investments may provide higher rewards.

Floating Rate Fund Investment Examples

Floating-rate funds can hold any floating-rate instrument. Most variable-rate funds buy bonds or loans. Two prominent floating-rate funds are below.

FLOT: iShares Floating Rate Bond ETF

The FLOT aims to match the price and yield performance of the Barclays Capital U.S. Floating Rate Note <5 Years Index. Each note has a maturity of less than five years, although the coupon rates are usually the one- to three-month LIBOR rate plus a spread.

The worldwide interbank market for short-term loans uses LIBOR as the interest rate for banks to lend cash to each other. LIBOR is the average interest rate based on daily estimates from the top worldwide banks.

The FLOT has investment-grade floating rate notes from Goldman Sachs, Inter-American Development Bank, and Morgan Stanley. With over $5.79 trillion in assets under management as of September 2020, the fund has a 0.20% cost ratio and 1.89% 12-month yield.

The iShares Short-Term Corporate Bond ETF

The iShares Short-Term Corporate Bond ETF buys investment-grade bonds with one- to three-year maturities. With $20.2 billion in assets, the product offers a 0.06% cost ratio and a 2.62% 12-month yield.

The Difference Between Money Market and Floating Rate Funds

Money market funds are mutual funds that invest in liquid cash and cash equivalent assets with solid credit ratings. Known as money market mutual funds, these funds invest in debt-based investments with a short-term maturity of less than 13 months, offering high liquidity and minimal risk. Compared to variable-rate funds, money market funds pay less.

However, variable-rate funds are riskier than money market funds. Money market funds buy high-quality assets, whereas variable-rate funds buy loans.

Floating-rate fund limitations

Floating rate fund credit risk may bother investors who want income but are wary of risk. Low U.S. Treasury rates favor floating-rate funds over Treasury bonds. Treasuries are safe since they’re U.S. government-backed.

Floating-rate funds may contain bad corporate bonds or default-risk loans. Investors must assess the risks and examine the fund holdings before investing in floating funds, which give returns when rates rise.

Other short-term bond funds that invest in Treasury bonds may have a fixed rate or lower yield than variable-rate funds. Each investment’s risks and rewards must be considered before investing.

Conclusion

  • Floating-rate funds invest in financial products with variable or floating interest rates. A floating-rate fund buys bonds and securities with variable interest rates.
  • Floating-rate funds include business bonds and bank loans. Repackaged loans are occasionally included in investor funds. However, loans may default.
  • Although floating funds give returns in a rising rate environment since they move with rates, investors must balance the risks and investigate the fund holdings.

 

 

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