What Is a Floating Rate Fund? Definition, Example and Limitations

What Is a Floating Rate Fund?

A floating rate fund is a fund that invests in financial instruments that pays a variable or floating interest rate. A floating rate fund, which can be a mutual fund or an exchange-traded fund (ETF), invests in bonds and debt instruments whose interest payments fluctuate with an underlying interest rate level. Typically, a fixed-rate investment will have a stable, predictable income. However, as interest rates rise, fixed-rate investments lag behind the market since their returns remain fixed.

Floating rate funds aim to provide investors with a flexible interest income in a rising rate environment. As a result, floating-rate funds have gained in popularity as investors look to boost the yield of their portfolios.

How a Floating Rate Fund Works

Although there is no formula to calculate a floating rate fund, there can be various investments that comprise a fund. Floating rate funds can include preferred stock, corporate bonds, and loans that have maturities from one month to five years. Floating rate funds can include corporate loans and mortgages as well.

Floating rate loans are loans made by banks to companies. These loans are sometimes repackaged and included in a fund for investors. Floating rate loans are similar to mortgage-backed securities, which are packaged mortgages that investors can buy into and receive an overall rate of return from the numerous mortgage rates in the fund.

Floating rate loans are considered senior debt, meaning they have a higher claim on a company's assets in the event of default. However, the term "senior" doesn't represent credit quality, only the pecking order of claiming a company's assets to pay back the loan if the company defaulted.

Floating rate funds can include floating rate bonds, which are debt instruments whereby the interest paid to an investor adjusts over time. The rate on a floating rate bond can be based on the fed funds rate, which is the rate set by the Federal Reserve Bank. However, the return on the floating rate bond is typically the fed funds rate plus a set spread added to it. As interest rates rise, so does the return on the floating rate bond fund.

What Does a Floating Rate Fund Tell You?

The biggest advantage of a floating rate fund is its lower degree of sensitivity to changes in interest rates, compared with a fund or instrument with a fixed payment rate or fixed bond coupon rate. Floating rate funds appeal to investors when interest rates are rising since the fund will yield a higher level of interest or coupon payments.

Floating rate funds are an attractive investment for the fixed income or conservative portion of any portfolio. A floating rate fund can hold various types of floating rate debt including bonds and loans. These funds are managed with varying objectives similar to other credit funds. Strategies can target credit quality and duration. The rates payable on a floating rate instrument held within a floating rate fund adjust with a defined interest rate level or a set of parameters.

As a result, floating rate funds are less sensitive to duration risk. Duration risk is the risk that interest rates will rise while an investor is holding a fixed income investment and thus missing out on higher rates in the market.

Income paid from a floating rate fund’s underlying investments is managed by the portfolio managers and paid to shareholders through regular distributions. Distributions may include income and capital gains. Distributions are often paid monthly, but they can also be paid quarterly, semi-annually, or annually.

Apart from their lower sensitivity to interest rate changes and the ability to reflect current interest rates, a floating rate fund enables an investor to diversify fixed-income investments, since fixed-rate instruments often comprise the majority of bond holdings for most investors. Another benefit is that a floating rate fund enables an investor to acquire a diversified bond or loan portfolio at a relatively low investment threshold, rather than to invest in individual instruments at a larger dollar amount.

In evaluating a floating rate fund, investors must ensure that the securities in the fund are adequate for their risk tolerance. Floating rate funds offer varying levels of risk across the credit quality spectrum with high yield, lower credit quality investments carrying considerably higher risks. However, along with the higher risk comes the potential for higher returns.

Examples of Floating Rate Fund Investments

Floating rate funds can include any type of floating rate instrument. The majority of floating rate funds typically invest in floating rate bonds or loans. Below are two popular floating rate funds.

The iShares Floating Rate Bond ETF (FLOT)

The FLOT seeks results that correspond to both the price and yield performance of the Barclays Capital US Floating Rate Note <5 Years Index. In other words, each note has a maturity of fewer than five years, but typically the coupon rates are an aggregate of the one to three month LIBOR rate plus a spread added to it.

LIBOR represents the interest rate at which banks offer to lend funds to one another in the international interbank market for short-term loans. LIBOR is an average value of the interest rate, which is calculated from estimates submitted by the leading global banks on a daily basis

The FLOT holds investment-grade floating rate notes, which include holdings or notes from Goldman Sachs Group, Inc., Inter-American Development Bank, and Morgan Stanley. The fund has an expense ratio of 0.20% and a 12-month yield of 1.89% with over $5.79 trillion in assets under management as September 2020.

The iShares Short-Term Corporate Bond ETF (IGSB)

The iShares Short-Term Corporate Bond ETF invests in corporate bonds that are investment grade and have maturities of one to three years remaining. The fund has an expense ratio of 0.06% and a 12-month yield of 2.62% with $20.2 billion in assets under management.

The Difference Between Money Market Funds and Floating Rate Funds

A money market fund is a kind of mutual fund which invests only in highly liquid cash and cash equivalent securities that have high credit ratings. Also called a money market mutual fund, these funds invest primarily in debt-based securities, which have a short-term maturity of fewer than 13 months and offer high liquidity with a very low level of risk. Money market funds typically pay a lower rate compared to floating rate funds.

However, floating rate funds carry a higher risk than their money market counterparts. Money market funds invest in high-quality securities versus floating rate funds, which can invest in below investment grade securities such as loans.

The Limitations of Using Floating Rate Funds

Credit risk of floating rate funds can be a concern for investors who seek yield but are hesitant to take on the added risk to achieve that yield. If U.S. Treasury yields are low, floating rate funds tend to appear more attractive than Treasuries. However, Treasuries offer safety since they're back to the U.S. government.

Floating rate funds could have holdings that include corporate bonds that are close to junk status or loans that have default risk. Although floating funds offer yields in a rising rate environment (since they fluctuate with rising rates), investors must weigh the risks of investing in the funds and research the fund holdings.

There are other short-term bond funds that primarily invest in Treasuries, but these funds might offer a fixed rate or a lower yield than floating rate funds. Investors need to weigh the risks and returns of each investment before making a decision.