Why Floating Rates Are All the Rage with Investors

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Bank loans are all the rage as investors look for higher yields and more certain returns. Investors have flocked to new loan funds as a way to get more fixed-income exposure at a higher yield.

Two of the biggest plays are floating rate notes and basic, senior loans.

Here's why investors love these funds:

  • Little rate risk – Floating rate notes and bank debt offer investors the opportunity to ignore bond convexity, the change in bond prices when interest rates move up or down. Buying into a loan portfolio of floating rate debt gives investors more upside when rates rise, but lower returns when rates fall. So far, investors like the idea of having less rate exposure when rates teeter on record lows.
  • Junk exposure – While many of the loans held in popular funds are unrated, it's generally understood that they would be seen as lesser than investment grade paper. Investors are rewarded for the risk with higher yields, but unlike junk bonds, investors have little to no exposure to a ratings change or shift in risk profile that would send yields higher or lower. Funds like the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEMKT: HYG) and the SPDR Barclays Capital High Yield Bond ETF (NYSEMKT: JNK) have no exposure to floating rate bonds. Rather, investors hold all the risk that rates will rise and bond prices will fall in response.
  • Seniority – A senior loan portfolio like the PowerShares Senior Loan Portfolio (NYSEMKT: BKLN) holds debt that is senior to the claims of stockholders and other creditors. While this is a high-risk, high-yield fund, investors are not exposed to mezzanine debt, debt which is often lost and 100% unrecoverable in the event of a bankruptcy. For all intents and purposes, seniority is akin to having investments in higher-quality securities.

  • Alternatives to risk-free income - A floating rate fund is an excellent alternative to low-yielding, risk-free investments. While these funds are hardly risk-free like US Treasuries or certificates of deposit, they do offer up the opportunity for CD-like returns with upside if rates rise higher. Additionally, investors are not exposed to reinvestment risk, given that it is quite possible rates will rise over the intermediate term. 

The many choices in loans and floating-rate notes

There are a few excellent choices for investors wanting exposure to floating-rate funds and notes.

For investors: The best long-term choice is the PowerShares Senior Loan Portfolio, which offers an excellent 5.8% average yield to maturity with an average time to maturity of 5.04 years. This growing fund is one of investors' favorites with more than $2.3 billion in assets under management. This fund is most suitable for investors with a higher risk tolerance and long-term focus. The yield on this ETF is very much in line with the yields on junk bond ETFs, but without the rate risk.

For income seekers: Interest rates on CDs are much too low with too much reinvestment risk. Those who want a place to store cash in the short-term might prefer the iShares floating Rate Note ETF (NYSEMKT: FLOT), which has an average maturity of 1.6 years and a weighted average coupon of .90%, giving the fund an average yield to maturity of .63%. Otherwise, the SPDR Barclays Investment Grade Floating Rate ETF (NYSEMKT: FLRN) has an average maturity of 1.42 years and a yield to maturity of .60%. The SPDR is less expensive than the iShares fund, giving it an edge in total returns for investors looking solely at returns in the short-term.

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