Money can’t be this cheap forever. In other words, one of the most likely scenarios the US economy faces is rising interest rates. The current low-interest-rate climate is simply unsustainable. At some point—as it always does—the trend will turn around. We want to be prepared for that turn, and the right floating-rate fund can help.
A floating-rate loan is a bank loan with interest that’s tied to some benchmark rate, often the London Interbank Offer Rate (LIBOR). When the LIBOR changes, so does the loan’s coupon. The rate is adjusted every 30-90 days. Floating-rate funds are pools of capital that invest in these loans, earn variable-rate interest, and pay dividends that are themselves flexible.
Variable Dividends Boost Immunity
Variable dividends are the key feature of floating-rate funds. They’re what separate floating-rate funds from the rest of the debt market. Flexible dividends make shares of the bond funds immune to rising interest rates; the prices of the bonds and the fund’s shares don’t get punished when rates go up. What the investor sees is higher dividends; his principal is safe.
A note of caution is in order here: Even though floating-rate bonds don’t have the same inverse price-yield relationship as fixed-rate debt instruments, their prices can still go down. Although the automatic coupon adjustments mostly eliminate the first major risk of any debt instrument—interest-rate risk—floating-rate funds still hold the other major risk: credit risk. As a reminder, credit risk is the risk that the borrower won’t make payments on time or will default on the debt entirely.
The credit risk of floating-rate loans is high because the companies that borrow under these conditions are usually rated below investment grade. They can’t go to capital markets for money because fixed-rate loans would be too expensive, so they turn to banks that provide funds on floating-rate terms.
