What is a Floating Rate Fund?

Pros and cons of floating rate funds.

Money floating on raft.
Floating rate funds pay an adjustable interest rate. G P Kidd / Getty Images

A floating rate fund is a mutual fund that holds loans made by large companies. These loans don't pay a fixed interest rate. Instead, the interest rate is adjustable, in much the same way that an adjustable rate home equity loan works. Because the interest rate adjusts, the rate is said to "float."

Floating rate funds are also called "bank loan funds," "prime rate funds" or "loan participation funds."

Why Would I Want a Floating Rate Fund?

Because the interest rates on the loans adjust, what this means for you as an investor, is that as interest rates rise, you would expect the interest payments you receive from a floating rate fund to increase. Higher yields can be attractive, but remember there's no free lunch when it comes to investing. Higher yields come with higher risks.

Because of the adjustable rate of interest, it makes sense to own floating rate funds over time periods where you expect interest rates to rise, and less sense to own floating rate funds during times where you expect interest rates to decline. However, it is quite difficult to predict the timing of the rise or fall of interest rates. For that reason, floating rate funds, like most investments, are best used as part of a diversified portfolio.

The share price of a floating rate mutual fund will fluctuate daily. If you own the fund long enough, the interest received should make up for any downward movement in share price, but this is not guaranteed.

 

Cautions About Floating Rate Funds

The advantage of investing in a mutual fund is diversification - your floating rate fund would own hundreds of loans issued by many companies. Often floating rate notes are issued by companies who need the money and have to pay a premium to get it. The company may be experiencing risk or financial problems.

Higher risk investments must pay a higher yield to attract investors. One of the underlying loans could default (stop making payments) which would affect the share price of the fund in a negative way. It is the fund manager's responsibility to evaluate the quality of the loans to help prevent this from happening. But, there is always the risk that the share price will go down.

The ability to buy or sell a floating rate fund may be limited. Before you buy a fund see if it offers daily liquidity, or only allows you to sell shares every thirty days, or once a quarter. Also, check to see if there are surrender charges if you sell your shares before holding them for a minimum amount of time. Liquidity may not be a problem if you have a long-term perspective. If you need your money freely available, stick with safer and more liquid investment choices

Before you invest, you always want to check on the expenses inside the fund. Some funds have higher expenses than others. If one is charging more, find out why.

One more risk to be aware of is the floating rate fund's use of leverage. Leverage is when the fund borrows money to make additional investments. Some floating rate funds can use leverage, and some can't.

If they can use leverage, this increases your chances for gains - and for losses. 

Floating Rate Funds for Retirees

Retirees who are sophisticated investors might consider floating rate funds for a portion of their portfolio. If you are relying on the interest income, expect that it will vary from year-to-year.

Another option that is less risky is to use high-quality bonds to build a bond ladder where the bonds mature in the years you'll need to take withdrawals.