No rising rates, no problem: Floating-rate funds still appealing

Steady-rate outlook has investors fleeing, leaving value play for some

Jan 27, 2012 @ 11:26 am

By Jason Kephart

When the Federal Reserve started signaling that interest rates were going to stay at near zero for the next few years, investors started to wean themselves off their floating-rate bond funds. Investors have pulled more than $9 billion out of floating-rate bond funds since November, after it was one of 2011s hottest-selling mutual fund categories with net inflows of $22 billion in the first 10 months of the year, according to Morningstar Inc.

But Adam Jordan, director of investment research and management at Paul R. Ried Financial Group, LLC, sees the selling as an opportunity to buy.

“Everyone's getting away from them because they assume rates are going to stay low, but with the bonds you're at least picking up decent yield and more protection than your average high-yield bond fund,” he said. Jordan is slowly building up the floating-rate bond fund allocation in his client's portfolios from 10% to 15% of fixed income.

Floating-rate bonds were popular last year because the market was betting on rates' rising in late 2011 or 2012. The bonds are typically tied to an index, such as the London Interbank Offered Rate, and when rates rise, so do the yields on the bonds. So it's one of the rare fixed-income instruments that offer protection against rising interest rates. Now that the Fed has taken its low interest rate outlook a step further, to the end of 2014, it's likely more outflows are on the way.

Jeffrey Rosenberg, chief investment strategist for fixed income at BlackRock Inc., said that's exactly the opposite of what investors should be doing. Floating- rate bond funds act as insurance against rising interest rates. The cheapest time to buy insurance is when the sun is shining, he said. “Last year people started buying because it looked like it was going to rain.”

A lot of investors also tend to forget, however, that the interest rates are only one aspect of floating-rate bonds, Mr. Rosenberg said. The bonds also carry lower-quality credit risk, which is why the yields, typically around 5%, are closer to that of a high-yield bond fund than an investment-grade bond fund.

Mr. Rosenberg said the underlying fundamentals of the credit quality of the bonds haven't deteriorated because the U.S. economy is growing. Today the Commerce Department announced the U.S.'s gross domestic product grew 2.8% in the fourth quarter of 2011, the fastest pace in more than 18 months. Mr. Rosenberg expects there to be fewer defaults priced into the market as growth continues, making this an attractive entry point for floating-rate bond funds.

“The real appeal of floating-rate bond funds now is yield for taking on the credit risk; the floating-rate part is an added bonus,” Mr. Rosenberg said.

The credit risk also brings about the biggest risk the bonds face this year, since it would be hard for interest rates to sink any lower than they are today. Every type of credit-risk-focused bond took a hit in 2011 when fears that the European sovereign debt crisis would lead to a global recession. Another scare could cause risk assets to tumble again.

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