With interest rates near historic lows, bonds can seem unexpectedly risky.

"At times like these, floating rate funds can look appealing," says Benjamin Sullivan, client service manager at Palisades Hudson Financial Group, a planning firm in Scarsdale, N.Y. Floating rate funds acquire loans made by banks and other lenders, often to companies with credit ratings below investment grade.

"Bank loans offer investors an opportunity to receive solid income, now about 4%-5%, and also potentially hedge interest rate risks," says Brad Kasper, president and chief financial officer at Lee's Summit, Mo.-based LSA Portfolio Analytics, which provides active investment management to independent advisors. "If we see interest rates move higher over the next few years, this investment has an opportunity to lock in greater income along the way."

"Floating rate funds should offer the protection from rising rates that traditional bonds lack," says Sullivan, partly because the loans held by the funds have variable interest rates. "The interest rates paid on the loans typically reset every 30 to 90 days, so investors start to earn the benefits of rising rates without paying much of a price through losses in principal."


Such funds can be extremely volatile. "The average floating rate fund lost almost 30% in 2008 and gained nearly 42% in 2009," says Sullivan. "We believe that fixed income investments should be used to reduce portfolio volatility, cover near-term cash needs, and preserve dry powder to deploy opportunistically in a market downturn."

Floating rate funds don't fit neatly into that mold, so Sullivan says they should not serve as the core of a fixed income portfolio. Instead, they may serve other purposes. "Besides hedging against rising interest rates," he says, "they also provide the opportunity to capture the higher yields paid by lower quality companies, without taking on the interest rate risk of a typical high-yield bond fund, which has a duration of more than four years."

Moreover, the loans held by floating rate funds are relatively safe, Kasper says. "Bank loan default rates continue to be at all-time lows," he says, "around 2%."


Sullivan says most of his firm's clients with fixed income allocations have some exposure to these funds. But because of the funds' volatility, Sullivan recommends clients allocate no more than 15% of their fixed income portfolio to floating rate funds.

The asset class' 2008 downturn was "a crisis of liquidity," Kasper says. "It was difficult for managers to raise capital for redemptions." And, he says, liquidity continues to be a concern. "Investors should be targeting managers who have a line of credit that they can access, or who have otherwise addressed how they would navigate if we were to see another liquidity crisis."

Kasper adds that bank loans "held strong" in February 2015, in the face of a rising 10-year Treasury rate. "This played nicely into the thesis that over a longer-term interest-rate-rising environment, we like the opportunity to be a beacon of light in what could be a difficult fixed income cycle."

Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.

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