Steve Merrell, co-founder andfinancial advisor at Monterey Private wealth, was asked to comment on the Wall Street Journal's article, "Moving Up in Floating Rate Bonds" by Murray Coleman, published on September 11, 2013.
Floating rate bond funds are providing some shelter in a rising-rates storm, but advisers see reasons to become more careful in picking where investors seek protection.
The growing popularity of floating rate bonds, which are often called bank loans, has led to a boom in issuance of these short-term securities. The majority of such activity is rated below investment-grade, and in some cases, involves increasingly risky leverage levels, portfolio managers point out.
So far in 2013, more than $320 billion in new floating rate bonds with credit ratings of below investment-grade have been issued, estimates S&P Capital IQ analyst Steve Miller. By year's end, he is projecting that number will be close to $450 billion, some 23% more than the market's record set in 2007.
"We still like floating rate bonds, but they're looking more like a crowded trade with both investors and issuers pouring into the market," says Craig Gentry, chief investment strategist at Destination Wealth Management in Walnut Creek, Calif., with $1.3 billion in assets.
Assets in mutual funds and exchange-traded funds investing in floating rate notes have soared more than 80% in the past 12 months to top $147 billion, according to S&P Capital IQ.
Rates on bank loans are generally tied to interest-rate benchmarks that reset every three months or so, giving a boost to investor returns as rates rise. As a result, they tend to be less sensitive to interest-rate swings than fixed-rate bonds.
But since the Federal Reserve has started to signal a winding down of its $85-billion-a-month bond-buying program, spurring a broad selloff, floating rate funds have proven a mixed bag. They have held up better than most classes of fixed-rate bond funds, but not all. And some floating rate funds have performed much better than others.
The most popular exchange-traded fund of its kind is the $5.4 billion PowerShares Senior Loan Portfolio. Since late May, its net asset value has lost around 0.6%, as of Tuesday.
While that compares favorably to funds with longer durations, a measure of interest rate sensitivity, Morningstar data show it is more than twice the slide of the average ultrashort-term fixed-rate bond mutual fund or ETF. Ultrashort funds are those with average effective maturities of less than one year.
Meanwhile, the $3.1 billion iShares Floating Rate Bond ETF has actually generated a slight gain since late May. Why the difference in returns from funds in the same group? The PowerShares ETF focuses on below investment-grade issues, while its iShares rival invests in more highly rated bonds.
"Floating rate bonds should generally hold up better in a rising rate environment, but not all funds are created the same," says Sara Craven, a senior portfolio manager at Sand Hill Global Advisors in Palo Alto, Calif., with $1.2 billion in assets.
Greater market turbulence is likely to leave floating rate funds targeting below investment-grade bonds more vulnerable to increasing downward pressure on prices, says Ms. Craven. She is currently leaning to higher-rated issues.
Many investors haven't focused enough on the nuances of the floating rate fund market, says Steven Merrell, chief investment officer at Monterey Private Wealth in Monterey, Calif., with $300 million in assets.
"In a rising rate environment, diversifying a portfolio to include higher quality funds is an attractive way for investors to minimize their risks while still taking advantage of the built-in benefits of owning floating rate bonds," Mr. Merrell says.
Another concern for advisers is the move by more highly leveraged companies into the market.
Leverage ratios of new deals are at elevated levels, according to analyst Mr. Miller, though not yet at heights reached in the market's boom years of 2006 and 2007. "From a historical perspective, we're somewhere in the mid-range," he says. "But the number of highly leveraged deals in floating rate securities is definitely increasing."
Investors starved for income often face a stark trade-off, however. The investment-grade iShares ETF, for example, is yielding less than 0.4%. With its lower-rated credit profile, the PowerShares ETF is paying out around 4%.
Mr. Gentry doesn't see a reason for investors to abruptly bail out of floating-rate funds using lower-rated loans. Last week, he says, his firm's portfolio managers started to increase positions of investment-grade funds in the group, which they see "as a complement, not a replacement, for noninvestment-grade floating rate funds."
Coleman, Murray. "Moving Up in Floating Rate Bonds." Wall Street Journal 11 Sep. 2013. WSJ.com.