What is a floating‑rate fund?
A floating‑rate fund is a mutual fund or ETF that invests in debt instruments whose coupon payments reset periodically based on a reference interest rate (for example, SOFR, the fed funds rate, or historically LIBOR) plus a fixed spread. Because the coupons adjust with market rates, the fund’s income—and its sensitivity to interest‑rate moves—changes over time, making these funds less exposed to interest‑rate (duration) risk than conventional fixed‑rate bond funds.
Why investors use them (quick summary)
– Seek protection when interest rates rise: yields on the fund’s holdings typically increase as the reference rate rises.
– Diversify fixed‑income exposure: floating‑rate funds add instruments with variable coupons to a portfolio otherwise dominated by fixed‑rate bonds.
– Potentially higher income than money market funds when rates are rising (but at higher credit and liquidity risk).
How floating‑rate instruments work (simple mechanics)
– Coupon = Reference rate + Spread. Example: 3‑month SOFR + 250 basis points.
– Reset frequency varies: daily, weekly, monthly, or quarterly depending on the security.
– Types of instruments included: floating‑rate notes, bank loans (senior secured or unsecured), some preferreds, and mortgage/ABS structures with floating coupons.
– Bank loans are often “senior” in the capital structure (higher claim in bankruptcy) but can still carry substantial credit/default risk.
Key benefits
– Low sensitivity to duration/interest‑rate increases.
– Income that tracks (with a lag) prevailing short‑term rates.
– Access to a diversified pool of floating‑rate credit without having to buy individual loans or bonds.
– Often pay regular distributions (monthly, quarterly, etc.).
Primary risks and limitations
– Credit risk: many floating‑rate funds include below‑investment‑grade loans or bonds that have higher default risk.
– Liquidity risk: some underlying loans trade infrequently; ETFs typically maintain intraday liquidity, but NAV may be affected by underlying illiquidity.
– Spread compression: if credit spreads tighten, fund returns can fall even if reference rates rise.
– Fee drag: expense ratios and trading costs reduce net yield.
– No free lunch in falling‑rate environments: when rates drop, floating incomes fall (so these funds don’t provide the price appreciation that long‑duration fixed bonds might during rate declines).
– Tax considerations: interest income is generally taxed as ordinary income (unless held in tax‑advantaged accounts or in tax‑exempt munis).
Common reference rates (note on LIBOR)
– Historically many floating instruments referenced LIBOR. LIBOR has been largely phased out and replaced in many markets by alternative reference rates such as SOFR (Secured Overnight Financing Rate) in the U.S. Funds now typically reference SOFR, the fed funds rate, or other benchmark rates. Always check a fund’s prospectus for the reference rate it uses.
Examples (types of funds)
– Floating‑rate note funds: focus on investment‑grade or high‑quality floating rate notes.
– Bank loan funds: invest primarily in syndicated corporate loans (often senior secured, may be below investment grade).
– Short‑term corporate bond funds: may include some floating components or very short fixed maturities that reduce duration.
– ETFs: many ETFs replicate floating‑rate indexes and provide intraday liquidity.
Two funds commonly cited as examples (verify current details before investing)
– iShares Floating Rate Bond ETF (FLOT) — tracks a short‑maturity floating‑rate note index (notes <5 years).
– iShares Short‑Term Corporate Bond ETF (IGSB) — invests in short‑maturity, investment‑grade corporate bonds (mostly fixed rate; included here for contrast).
(Check current fund pages for up‑to‑date yields, expense ratios, holdings and AUM.)
How to evaluate a floating‑rate fund — practical checklist
1. Investment objective and strategy
– What type(s) of floating instruments does the fund hold (bank loans, notes, ABS)?
– Is the fund actively managed or index‑tracking?
2. Reference rate and reset terms
– Which benchmark is used (SOFR, fed funds, LIBOR historically)? How often do coupons reset?
3. Credit quality and average rating
– Average credit rating of holdings; percentage of below‑investment‑grade assets.
4. Maturity and duration profile
– Average maturity or weighted average life; effective duration (expect low duration for floating funds).
5. Yield measures
– 12‑month yield, SEC yield, current distribution rate—understand the difference between these metrics and how they are calculated.
6. Fees and expenses
– Expense ratio and any additional trading costs (bid/ask spreads for ETFs; loads for mutual funds).
7. Liquidity and structure
– Mutual fund vs ETF: ETFs offer intraday trading; mutual funds trade at end‑of‑day NAV.
– Underlying loan liquidity: bank loans may be less liquid than traded bonds.
8. Manager experience and track record
– Especially important for actively managed funds that select credit.
9. Taxation
– How are distributions taxed (ordinary income vs qualified/dividends)? Any muni‑version funds for tax‑exempt income?
10. Operational details
– Distribution frequency, minimum investment, creation/redemption mechanics (for ETFs).
Step‑by‑step: How to add floating‑rate exposure to your portfolio
1. Define your objective
– Are you seeking a hedge against rising rates, higher current income, or diversification from long‑duration bonds?
2. Assess your risk tolerance
– If you want minimal credit risk, favor investment‑grade floating‑rate note funds; if seeking yield and willing to accept credit risk, consider bank‑loan funds or high‑yield versions.
3. Decide fund vehicle
– ETF for intraday liquidity and potentially lower costs. Mutual fund if you prefer dollar‑cost averaging or institutional share classes.
4. Screen and compare candidates
– Use the checklist above (credit quality, average maturity, yield metrics, fees, AUM, and holdings). Compare several funds in the same strategy bucket.
5. Read the prospectus and holdings
– Confirm reference rate, reset frequency, use of leverage, and policy on illiquid securities. Look at top holdings to understand issuer concentration.
6. Execute the trade in the appropriate account
– Use taxable accounts, IRAs, 401(k)s as per tax considerations. For taxable accounts, consider tax‑efficient alternatives (e.g., tax‑exempt floating municipal funds if available and suitable).
7. Monitor and rebalance
– Check performance, distribution stability, changes in credit quality, and spread movements. Rebalance periodically to maintain target allocation.
8. Have an exit criterion
– Examples: credit quality deterioration beyond a threshold, material increase in fund fees, manager change, or simply rebalancing away as interest‑rate expectations change.
Practical allocation ideas (illustrative, not advice)
– Conservative investor seeking rate protection: 5–15% of fixed‑income sleeve in high‑quality floating‑rate note funds or short‑term floating ETFs.
– Yield‑seeking investor comfortable with credit risk: 10–30% in a blend of bank‑loan funds and higher‑yield floating vehicles (monitor defaults and manager quality).
– Tactical allocation: increase exposure when you expect rates to rise materially; reduce exposure if you expect rates to fall and prefer duration exposure instead.
Other comparisons
– Floating‑rate funds vs money market funds: Money market funds focus on cash equivalents and very short maturities with high credit quality and very low risk—yields are usually lower but principal stability is higher. Floating‑rate funds generally offer higher potential yield at materially higher credit and liquidity risk.
– Floating‑rate funds vs short‑term bond funds: Short‑term bond funds may have fixed coupons and still carry duration risk; floating funds aim to reduce duration sensitivity.
Monitoring and red flags
– Rising default rates or downgrades in the fund’s portfolio.
– Significant change in average credit quality or a shift toward riskier holdings without clear disclosure.
– Persistent underperformance vs peers with similar objectives.
– Sharp widening of bid/ask spreads or NAV disconnects for ETFs (may signal liquidity stress).
Tax and account considerations
– Interest and loan income are generally taxed as ordinary income (unless from tax‑exempt municipal floating bonds or held inside tax‑deferred accounts).
– Some distributions may include return of capital or capital gains—check fund statements.
– Holding high‑yield or bank‑loan funds in tax‑advantaged accounts can be tax efficient for many investors.
Where to find reliable information
– Fund prospectus and statement of additional information (SAI).
– Fund performance page on the issuer’s website (for up‑to‑date yields, holdings, AUM, expense ratio).
– Independent fund screeners and rating agencies for fund comparisons.
Conclusion
Floating‑rate funds can be useful tools for investors who want to limit duration risk and seek income that adjusts with market rates. They provide diversified access to variable‑rate bonds and loans but carry credit and liquidity risks that vary by fund. Understand the fund’s holdings, reference rate, reset frequency, and fees; match the fund’s risk profile to your investment objectives; and monitor holdings and performance regularly.
Source
– Investopedia, “Floating‑Rate Fund”: https://www.investopedia.com/terms/f/floating-rate-fund.asp (consult the fund’s own website and prospectus for current, detailed fund information before investing).