Floating Rate Fund- Definition Howto Work, Examples, And More
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What is a Floating Rate Fund?
A floating rate fund is a fund that invests in financial instruments that pay a variable or floating rate of interest. A floating-rate fund, a mutual fund or an exchange-traded fund (ETF) invests in bonds and debt instruments whose interest payments fluctuate at a base interest rate level. A fixed-rate investment will generally have a stable and predictable income. However, fixed-rate investments lag behind the market as their yields remain flat as interest rates rise.
Floating rate funds aim to provide investors with flexible interest income in a high rate environment. As a result, floating-rate funds are becoming very popular as investors seek to increase the return on their portfolios.
How Does A Floating Rate Fund Work?
While there is no formula for calculating a floating rate fund, multiple investments can make up a fund. Floating-rate funds can include selected stocks, corporate bonds, and loans with maturities of one to five years. It can also include corporate loans and mortgages in floating rate funds.
Floating-rate mortgage-backed loans are similar to packaged mortgages, in which investors can buy and earn an overall rate of return on the fund’s many mortgage rates. Variable-rate loans are loans made by banks to businesses. Sometimes these loans are repackaged and included in a mutual fund.
Interest-rate loans will consider senior debt, meaning they have a higher claim on the company’s assets in the event of default. However, the term “senior” does not mean creditworthiness, but rather the parenting order to claim the help of a business to repay the loan if the company has failed.
Floating rate funds can be flowing rate bonds, which are debt instruments whereby the interest paid to an investor will adjust over time. The rate on a floating rate bond may base on the feed funds rate, which the Federal Reserve Bank sets. However, the floating rate bond yield is typically the rate on the feed funds and the fixed spread added. The bond fund’s yield becomes a floating rate as interest rates rise.
What Does A Floating Rate Fund Tell You?
The main advantage of a floating rate fund is its lower level of sensitivity to changes in interest rates than a fund or instrument with a fixed payment rate or a fixed bond coupon rate. The funds attract floating rates to investors when interest rates rise, as the fund will generate a higher level of interest or coupon payments.
As a result, floating-rate funds are less sensitive to long-term risk. Risk is when interest rates will rise while an investor holds a fixed income investment and misses out on higher market rates.
The portfolio managers manage the income paid on the underlying floating rate fund investments, delivered to shareholders through regular distributions. Allocations are often paid monthly but can be paid quarterly, semi-annually, or annually.
Aside from its lower sensitivity to changes in interest rates and ability to reflect current interest rates. A floating rate fund allows an investor to diversify from fixed-income investments. As most bond holdings tend to be fixed-rate instruments. Another benefit is that a floating rate fund allows a diversified bond investor to obtain a bond or loan at a relatively low investment threshold rather than investing in individual instruments for a higher dollar amount.
When considering a floating rate fund. Investors should ensure that the fund’s assets are sufficient to meet their risk tolerance. Variable-rate funds offer different levels of risk across the credit quality spectru. With high quality and lower credit quality investments carrying much higher stakes. However. Along with the increased risk comes the possibility of better results.
Examples of Investments in Floating Rate Funds
Floating rate funds can contain any floating rate instrument. Most floating-rate funds generally invest in floating-rate bonds or loans. Below are two popular floating-rate funds.
IShares Floating Rate ETF (FLOT)
The FLOT looks for results that match the price-performance and performance of the Barclays Capital US <5 Year Float Rate Index. Each note has a maturity of fewer than five years, but coupon rates plus spreads are typically an aggregate of one to three months LIBOR.
LIBOR reflects the interest rate banks offer to lend funds to each other in the international interbank market for short-term loans. LIBOR is a value of the average interest rate calculated from estimates present world banks daily.
FLOT holds investment-grade floating-rate notes, including holdings or notes of Goldman Sachs Group, Inc., the Inter-American Development Bank and Morgan Stanley.
IShares ETF Short Term Corporate Bonds (IGSB)
IShares Short Term Corporate Bond invests in investment-grade corporate bonds with one or three years remaining maturities. The fund has a cost ratio of 0.06% and a 12-month return of 2.62%, with $20.2 billion in assets under management.
Difference Between Money Market Funds and Floating Rate Funds
A money market fund is a mutual fund that invests only in highly liquid cash and cash-equivalent securities with high credit ratings. Also known as money market mutual funds. These funds invest primarily in debt-based securities, which have short-term maturities of less than 13 months and offer high liquidity with a shallow level of risk. Money market funds tend to pay a lower rate than floating rate funds.
On the other hand, floating rate funds are riskier than money market funds. In contrast to floating rate funds. Which may invest in investment-grade securities such as loans, money market funds invest in high-quality securities.
Limitations On The Use Of Floating-Rate Funds
The credit risk of floating-rate funds can be a concern for investors looking for a return but are reluctant to take additional risks to achieve that return. If US Treasury bond yields are low. Floating rate funds tend to be more attractive than funds. However, the funds provide security as they will return to the US government.
Floating-rate funds may have holdings that include corporate bonds close to junk status or loans at risk of default. While floating funds offer returns in a rising rate environment (since they fluctuate with rising rates). Investors should weigh the risks of investing in the funds and research their holdings.
Other short-term bond funds invest primarily in Funds. But these funds may offer a fixed rate or lower return than floating rate funds. Investors must weigh the risks and benefits of each investment before making a decision.
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