Portfolio: The risks of floating rate funds

Any yield-focused investor would be pleased with a portfolio that had no volatility, generated an annual return of about 4 percent and promised rising income in the years ahead. But all of the new money flowing into bank-loan funds should be a matter of concern.

Bank-loan funds have been around since the 1980s, when they were created by fund families such as Eaton Vance, Franklin Templeton Investments, and Oppenheimer. They are aimed at investors who wanted better than cash-equivalent returns. Those funds, often called floating-rate funds, hold short-term loans extended by banks to companies. The bank sells the loans to mutual funds and other institutional investors. In turn, the funds will buy and sell the bank loans on the open market.

Until 2009 bank-loan funds were a niche product among mutual funds. But recently, investors have been piling into them. Frustrated with paltry yields from savings accounts, certificates of deposit, and Treasury bonds, bank-loan funds yield twice as much as the Standard & Poor’s 500 Index.

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Investors, attracted by their floating rates, poured $60 billion into those funds in 2013, compared with $10 billion in domestic large-cap stock funds. Interest rates, which are based on the London Interbank Offered Rate, or LIBOR, are locked for short periods of time—about 30 to 90 days. Then, when rates rise—something that is likely to happen sooner rather than later—companies pay higher interest on their loans and the fund’s yield rises. For that reason, bank-loan funds do well in periods of rising interest rates, unlike most conventional bond funds.

It’s not that different from variable-rate credit cards. Usually, if the prime rate goes up, so does the annual percentage rate (APR) of a variable-rate credit card. Similarly, if interest rates go up, the creditor (the bank-loan fund) receives more in interest payments.

Investors, though, would be smart to cast a wary eye on bank-loan funds despite their superior yields (about 3.8 percent right now) and the promise that they will only go up. There are potential pitfalls.

Just as banks write off a percentage of the bad credit-card loans in their portfolio, there’s always the chance that the borrower may be unable to make payments on the bank loan, leaving the creditor—the mutual fund investor—out of luck. That’s particularly true in bank-loan funds that increasingly make loans to companies that may not have the greatest credit. With all of the new money in bank-loan funds chasing a limited number of bank loans, portfolio managers are sometimes less particular about which bank loans to buy.

Another worry is that although most funds own hundreds of bank loans at one time, historically loans tend to go bad simultaneously, concurrent with economic conditions. Although bank-loan funds have returned more than 9 percent annually over the past five years, the potholes, like 2008, can be as deep as they were for stocks. Bank-loan funds lost 29.7 percent in that year—more akin to the 37 percent loss of stock funds than the 4 to 5 percent loss in corporate bond funds.

Then there are the fees. Bank-loan funds are relatively expensive propositions, costing investors 1.14 percent annually, according to Morningstar. Part of that expense can be attributed to brisk buying and selling of bank loans: The average turnover of a bank-loan fund was about 70 percent last year. That means that in any 12-month period a bank-loan fund with $10 billion in assets bought and sold $7 billion worth of loans.

If you still decide to invest in bank-loan funds, consider the caveats above, and treat them as an alternative investment—not as a high-yielding substitute for the bond portion of a portfolio. It would also be a good idea to find a manager with expertise in those kinds of investments. Below, we screened for some of the better-performing funds in the category over the past decade: funds with low costs, better returns, and lower turnover than their peers.

Bank shots

The two no-load bank-loan funds below have outperformed the benchmark, and their expenses are lower than the category average.

Data: Morningstar. Returns as of April 30, 2014.

This article also appeared in the July 2014 issue of Consumer Reports Money Adviser.