Floating Rate Funds: What They Are And How They Work

Designing a well-diversified portfolio is part of any good investment strategy. And depending on your financial goals and life situation, one group of investments to consider adding are floating rate funds.

Despite their name, these fund tends to have a very stable price. It's called a floating rate because of the investments that the fund holds. A floating rate fund also generally holds senior-level debt. 

Most of their yields are similar to other fixed-income funds (like bonds funds), but could offer higher returns. Of course, higher returns usually mean higher risk. And floating rate funds are no exception. In this article, we’ll dig into what these funds are and how they work.

Capital Stack

To understand floating rate mutual funds, we must first look at the capital stack. The capital stack is the arrangement of different equity and debt funding.

Funds at the top of the stack have the most amount of risk, while those at the bottom have the least amount of risk. As you go from top to bottom of the stack, returns decrease as well. Below is an example of a capital stack structure:

• Common equity
• Preferred equity
• Mezzanine debt
• Senior Debt (i.e., bonds)

Risk in each level comes in the form of a liquidation event, which is another way of saying bankruptcy. Once a company files for bankruptcy, its assets must be liquidated to pay back investors in the capital stack. Payments are distributed in a specific order, which starts with debt and ends with equity.

When bankruptcy occurs, debt holders are made whole first. Whatever is leftover goes to equity holders. Of course, if there isn’t enough to make the debt holders whole, equity holders receive nothing, which is often the case.

Going back to more risks equals higher returns. Equity holders are able to participate in any upside. Bondholders only receiver their coupon payments and can’t participate in upside. For this limitation, they move up to the top of the capital stack payment hierarchy.

What Are Floating Rate Funds?

Floating rate funds are mostly debt funds. They invest in corporate debt. This is debt that is at the bottom of the capital stack (i.e., senior debt). Unlike a Treasury bond, corporate debt still comes with a fair amount of risk. This is especially true of the corporate debt within floating rate mutual funds as they often invest in companies with low-credit.

If a company files for bankruptcy, there’s no guarantee that the liquidation of its assets will be able to pay back bondholders. Not only do bondholders lose their regular coupon payments, but they also lose their principal. This credit risk is inherent to investing in corporate debt.

What Are Their Key Components?

In addition to their credit risk, any debt instruments that pay a fixed interest rate have an inherit "interest rate risk."  In other words, you could lose out if interest rates go up while you're locked in at a lower rate.

However, floating rate mutual funds are able to mitigate this "interest rate risk" by investing in debt instruments that offer variable interest rates. There are two components of these funds that allow for rates to move up and down. Both are detailed below.

1. Rates Frequently Reset Based On The Latest Interest Rates

Compared to most bond funds (which typically hold a basket of fixed-rate debts) floating rate funds are invested in variable-rate loans. The rates on these underlying loans generally adjust every 30 to 90 days, which significantly reduces interest-rate exposure.

An investor can mimic this strategy by frequently selling bonds and buying new ones. This would allow them to continually participate in current interest rates. However, this strategy is time-intensive and would increase transaction costs.

A floating rate fund does the above without investor participation or increased transaction cost. Examples of floating rate funds that invest in corporate debt include:

• Blackrock Floating Rate Income Fund (BFRIX) — YTD return: 11.70%, Expense ratio: 0.71%
• iShares Floating Rate Bond ETF (FLOT) — YTD return: 5.26%, Expense ratio: 0.15%
• SPDR® Bloomberg Barclays Investment Grade Floating Rate ETF — YTD return: 5.74%, Expense ratio: 0.15%

You can start investing in any of these funds by simply opening up an account with one of the top online brokers. And Fidelity customers can invest in its in-house floating rate fund — FFRHX.

2. Underlying Debt Instruments Based On A Floating Reference Rate

The reference rate for a floating rate fund might be the London Interbank Offered Rate (LIBOR) or the FED rate. A premium is then added to this base rate and that's what the corporations are charged.

There is another type of variable-rate mutual fund that invests in short-term treasuries rather than corporate debt. It's put out by WisdomTree and is called the Wisdom Floating Rate Treasury Fund.

• Wisdom Floating Rate Treasury Fund (USFR) — YTD return: 3.62%, Expense ratio: 0.15% 

Because this particular fund invests in treasuries, it doesn’t assume the same credit risk as floating rate funds that invest in corporate debt.

Related: How To Build A Diversified Bond Portfolio

Final Thoughts

With the recent drop in interest rates on savings accounts, CDs, and other deposit accounts, many investors may be looking for fixed-income investments that can offer better returns. Fixed-rate bonds could be an option. But they're likely to lose value, if and when, interest rise in the future.

Floating rate funds offer a third option. They may be able to offer better rates than deposit accounts today with less risk of losing their value if interest rates go up tomorrow. However, since these funds tend to invest in low-credit borrowers, they're also riskier than traditional bond funds.

Floating rate funds could be worth considering as an alternative to some of your portfolio's bond holdings to potentially boost returns. Just know that they're also riskier investments than other fixed-income funds.

That extra risk also means that floating rate mutual funds aren't good cash alternatives. If you're seeking a better return on your emergency savings, consider opening a high-yield savings account instead.