Floating-rate funds are growing in popularity with investors desperate for returns in a stormy investing environment, but they’ve also caused increasing concern among regulators. Last month, the Financial Industry Regulatory Authority (FINRA) issued an investor alert cautioning investors about the risks of the products.
Floating-rate funds are specialized bond funds that invest mainly in debt securities that don’t have fixed interest payouts. As reported Aug. 26 by MarketWatch, rather than holding debt from high-grade companies, floating-rate funds mostly invest in bank loans made to, or bonds issued by, companies with low-credit quality. The portfolios usually come with average credit ratings that are well below the definition of junk, according to the article.
The low credit quality of floating-rate bond funds could spell danger for investors. Not only are the funds less liquid, but they also carry much higher risk. Moreover, floating-rate funds basically buy loans that banks make to companies, and those loans are not securities that can be traded on a regulated exchange. This makes it even more difficult to figure out how much each loan is actually worth.
In 2008, floating-rate bond funds lost an average of 27%, according to Standard & Poor’s Equity Research. Meanwhile, high-yield bond funds lost 26%; short-term bond funds fell 3.4%. In 2009, floating-rate funds were up 41%, while high-yield funds rose 47% and short-term bond funds gained 9.5%.
“That schizophrenic performance profile should make clear that bank-loan investments are a bad idea for bond investors who value stability of principal above all else – the risk is simply too great,” said Christine Benz, director of personal finance at Morningstar, in the MarketWatch article.