Floating-Rate Funds: Choose Them Wisely

Steve Merrell, co-founder and financial advisor at Monterey Private wealth, was asked to comment on the Wall Street Journal's article, "Floating-Rate Funds: Choose Them Wisely," by Murray Coleman, published on September 13, 2013.

The article

The growing popularity of floating-rate bond funds has led to a boom in the issuance of these short-term securities. But advisers are cautioning investors to be more choosy before jumping in.

The funds invest in corporate debt issued with flexible interest rates. The majority of such loans bought by funds are rated below investment grade, and, in some cases, can involve risky levels of borrowing.

Assets in mutual funds and exchange-traded funds investing in floating-rate bonds, which often are called bank loans, have soared more than 80% in the past 12 months to top $147 billion, according to S&P Capital IQ.

Yields on many floating-rate funds now are comparable to those of short-term high-yield bonds that pay a fixed interest rate.

For example, the most popular ETF of its kind, the $5.5 billion PowerShares Senior Loan Portfolio, has a yield of 4.2%. That compares to the Pimco 0-5 Year High Yield Corporate Bond Index ETF's 3.7%.

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.
A Mixed Bag

But since the Federal Reserve has started to signal a winding down of its massive bond-buying program, spurring a broad selloff, floating-rate funds have proved 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.

"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., which has $1.2 billion in assets.

Since late May, the price of the PowerShares Senior Loan Portfolio has dropped 0.6%, as of Thursday—twice as much as the average ultrashort-term fixed-rate bond mutual fund or ETF, according to data from investment researcher Morningstar. Ultrashort funds are those with average effective maturities of less than one year.

Meanwhile, the $3.2 billion iShares Floating Rate Bond ETF has 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 higher-rated bonds.

Greater market turbulence is likely to leave floating-rate funds that hold below-investment-grade bonds more vulnerable to increasing downward pressure on prices, Ms. Craven says. She currently is leaning to higher-rated issues.

Many investors haven't focused enough on the nuances of the market, says Steven Merrell, chief investment officer at Monterey Private Wealth in Monterey, Calif., which has $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," he says.
A Stark Trade-Off

Another concern is the move by more companies with higher leverage, or borrowing levels, into the market.

Leverage ratios—which compare a company's debt to its cash flow—are at elevated levels for new deals, according to S&P Capital IQ analyst Steve 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 midrange," he says. "But the number of highly leveraged deals in floating rate securities is definitely increasing."

Yet investors starved for income often face a stark trade-off. The investment-grade iShares Floating Rate Bond ETF, for example, is yielding less than 0.4%, some 3.8 percentage points less than the PowerShares ETF. which has a lower-rated credit profile.

Coleman, Murray. "Floating-Rate Funds: Choose them Wisely." Wall Street Journal 13 Sep. 2013. www.wsj.com.