Floating-rate note funds should be avoided

Every time interest rates are low, investors begin to make mistakes, engaging in activities (such as stretching for yield by taking on credit risk) that they wouldn't do if rates were at more "normal" levels like 4 or 5 percent. Wall Street takes full advantage of this bad behavior by rolling out new products to exploit investors, and floating-rate note funds are just another example.

The seemingly insatiable demand for yield has fueled the demand for these funds (also known as bank loans, syndicated loans, leveraged loans and loan-participation funds) that invest in the variable interest-rate corporate loans originated by banks. The rates reset at regular intervals (such as monthly or quarterly) at a fixed spread over a benchmark like the London Interbank Offered Rate. Over the 12 months ended March 31, 2011, open-end floating-rate funds, which constitute 13 percent of the total floating-rate loan market, saw their assets increase by more than 50 percent, fueled by investor cash inflows of more than $27 billion. Fund companies are rushing in as well. More than 50 of these funds are now available. There's even an ETF, the iShares Floating Rate Note Fund (FLOT), which has an expense ratio of just 0.2 percent.

The appeal of these funds isn't only in the higher yield, but their floating-rate nature means they also provide some hedge against inflation -- a risk many are concerned about. Those benefits seem to blind investors to the negatives. The first is the increased credit risk, risk that tends to show up when equities take a dive as well. Thus, just when you need your fixed income assets to provide shelter from the storm -- as Treasuries do -- the risks of corporate loans show up, and your stocks and bonds are hit at the same time. This is exactly what happened in 2008 when floating-rate funds averaged losses of 29 percent, underperforming the Barclay's Capital U.S. Aggregate Bond Index by 34 percent. A second negative can be high costs. The average expense ratio is about 1.15 percent.

Before we go further, it's important to note that these funds are different from the floating-rate notes the government may be considering. The difference is credit risk: With Treasuries there is no credit risk for US investors.

Let's look inside these funds to see why you shouldn't invest in them, starting with the fact that the assets they hold are corporate loans made by banks. Companies with the strongest credits don't need to go to banks. They typically get their funding directly from the capital markets. So you won't typically invest in investment-grade credits. That means that while your investment isn't an equity investment, it has a significant amount of equity-like risk.

The bigger problem is that you're not being appropriately compensated for the risks: The bank may not be passing on the full credit spread, and the funds are taking a big cut of the spread in the form of their expense ratio. For example, the DWS Floating Rate Plus Fund (DFRAX) carries a sales load of 2.75 percent and has an expense ratio of 1.14 percent.

The result is that investors are taking all of the credit risk, but not receiving anywhere near the market's required return. And the "Plus" in the fund's name could well apply to the amount of credit risk investors are taking. As of Nov. 15, this $2.1 billion fund had a credit make up of:

The fund lost 28 percent in 2008, reflecting the nature of its credit risk and the equity-like nature of that risk.

We can see the equity-like nature of the risks of floating-rate note funds by looking at the correlations of their returns to various asset classes. For the period February 1992-April 2011, the correlation to both short-term and long-term Treasuries was negative, while the correlation was 0.74 to high-yield corporate debt and 0.42 to the U.S. equity market. In other words, they look a lot like junk bonds and a lot more like stocks than Treasury bonds.

Floating-rate funds do minimize interest rate sensitivity. And they've outperformed fixed rate debt during periods of rising interest rates. However, it's important to note that significant portions, if not all, of the excess returns earned during rising-rate periods would have been lost if investors were unable to successfully time their exits. And the evidence demonstrates that investors engaging in such tactical allocation strategies are unlikely to be successful.

The minimization of interest-rate sensitivity causes some investors to think floating-rate note funds are substitutes for money market accounts or other high-quality short-term investments. However, they cause investors to accept significant credit risk. Therefore, investors should view these funds like high-yield bond funds and not as an alternative to high-credit-quality bond holdings.

The bottom line is that if you want to take more risk (which is what you're really saying when you say you want more yield), it's more efficient to do so on the equity side where you can diversify it more effectively at less expense and earn the returns in more tax-efficient manner (capital gains instead of ordinary income). And for those who want inflation protection, TIPS are the clear preference.