Take Five: Credit risk could bring floating-rate funds back to earth

With the threat of higher interest rates ranked as a top concern of income-seeking bond investors, floating-rate bank loan investments have become popular alternatives. The growing appetite for bond yields that are pegged to the London Inter Bank Offered Rate was illustrated by the nearly $15 billion that poured into bank loan mutual funds during the first quarter. Although the floating-rate strategy certainly offers some advantages, J. David Hillmeyer, a senior portfolio manager at Delaware Investments, points out that not all floating-rate mutual funds are created equal and financial advisers should dig deep before allocating client assets. For instance, while about half the $1 trillion floating-rate bond market is made up of below-investment-grade bank loans, there are diversified strategies that also include investment-grade floating-rate bonds. InvestmentNews: How do floating-rate bonds offer protection against rising rates? Mr. Hillmeyer: The floating-rate note protects against rising rates because the coupon resets. Most reset on a quarterly basis, based on [Libor]. So your coupon will adjust every quarter. InvestmentNews: Where is the risk? Mr. Hillmeyer: With floating-rate bonds, you address the rate risk associated with bonds, but not the credit risk. Credit risk can come in different forms, and there can be more credit risk with some floating-rate loans. InvestmentNews: What kind of credit quality should investors expect when it comes to floating-rate bonds? Mr. Hillmeyer: If you're looking at a portfolio that is primarily bank loans, your average credit quality will be high single-B, which is firmly below investment grade. But floating-rate bonds don't necessarily have to be bank loans. InvestmentNews: How much of a floating-rate bond market is there beyond bank loans? Mr. Hillmeyer: At the end of the day, the total market of investments that are floating in nature is beyond $1 trillion, and about half of that is below investment grade. The bank loan market, which is below investment grade, has seen the most growth over the past decade. InvestmentNews: What should advisers look out for when researching floating-rate mutual fund strategies? Mr. Hillmeyer: The bank loan funds are all going to be similar, meaning they will have a below-investment-grade profile. It's also important to know that bank loans are callable at any time, and that's another risk factor. But if the portfolio is diversified and moves up in credit quality, you take out some of that call risk.