Floating-rate funds: How much risk?

In today's low-yield environment, investors have good reason to be concerned about the impact rising rates could have on their fixed-income portfolios.

However, it is important for investors to understand there are strategies that might help reduce interest rate risk within their portfolios. One such strategy: allocating part of a fixed-income portfolio to floating-rate investments.

It’s important to closely evaluate the type of floating-rate instruments in which they may invest, because certain securities might reduce interest rate risk while introducing other risks to the portfolio.

Many floating-rate mutual funds focus on a single asset class, investing almost exclusively in debt instruments known as bank loans (also referred to as senior secured loans, leveraged loans or loan participations). While bank loans have been a popular asset class in recent years, some debt investments other than bank loans also offer the benefit of low price sensitivity to interest rates. Furthermore, several factors can influence the value of floating-rate instruments.

RISK TOLERANCE

If fear surrounding rising interest rates is the primary reason to purchase floating-rate assets, investors might do well by evaluating their risk tolerance from a broader perspective. Is a single asset class strategy such as bank loans appropriate? Or might a diversified approach be a better alternative with potentially lower volatility?

Different asset classes offer varying degrees of protection against price volatility due to changing rates. Examples include high-yield corporate bonds, investment-grade corporate floating-rate bonds, asset-backed securities or even Treasury bills. As expected, each one of these asset classes comes with risks that may include credit uncertainty, insufficient income or perhaps more interest rate sensitivity than desired.

The features of diversification are well known. These same principles also can apply to a portfolio of floating-rate instruments. For instance, there may be times during the credit cycle when a certain asset class has a more attractive risk/reward profile than others. If an investor is considering only one asset class to limit interest rate risk, he could be investing in a strategy that introduces unnecessary risks into his portfolio.

Over the past several years, for example, investing in bank loan funds has become a conventional way for some investors to protect fixed-income portfolios against rising rates.

However, bank loans might not fit the risk profile of many investors, and the asset class is fully valued at current price levels. Although the bank loan market is considered very effective at limiting price volatility due to changing rates, it is a high-yield (“junk”) asset class, which generally carries a higher degree of credit risk than investment-grade corporate bonds.

Investment-grade corporate floating-rate bonds allow an investor to diversify risk and provide investment opportunities that are higher-rated than those of the bank loan market. In most instances they do not carry a LIBOR floor, which means investors will experience more income sooner when rates begin to migrate higher than instruments that carry an “in-the-money” floor.

CASH WON’T BEAT INFLATION

Some investors may even choose to remain in cash during a period of rising rates to protect their principal investment. However, the opportunity cost lost in yielding less than the current inflation rate likely will result in decreased purchasing power and likely won’t meet the risk/return objectives for many investors.

Investors have many choices within the fixed-income markets to evaluate when protecting their portfolios against rising rates. Single-asset-class strategies such as bank loans should minimize issues pertaining to rising rates but may not have the appropriate credit risk profile for all investors.

A diversified portfolio that takes advantage of bank loans, as well as other asset classes, to minimize liquidity, credit and curve risk may be an appropriate consideration in today’s environment of low yields and compressed risk premiums.

David Hillmeyer is vice president and senior portfolio manager at Delaware Investments.