Every time interest rates are low, investors begin to make mistakes. They tend to engage in activities that they otherwise wouldn’t undertake—such as stretching for yield by taking on credit risk—if rates were at more “normal” levels like 4% or 5%.
With Treasury yields having been at extremely low levels for seven years now, and with money market accounts paying virtually nothing, many investors haven’t been able to resist the siren call of higher yields, especially if they can get them without taking term risk (the risk of rising interest rates). Unfortunately, investors frequently seem to forget that yield and return aren’t synonymous.
In addition to the search for incremental yield, concern regarding the potential for rising interest rates has led many investors to seek alternative ways to protect against a rise in interest rates without sacrificing yield. The dual concerns have led many investors to consider floating-rate bond funds (also known as bank loans).
How Rates Are Set
Interest payments for floating-rate notes are determined based on a floating reference rate, such as LIBOR (the London Interbank Offered Rate), plus a fixed spread. Depending on the loan agreement, the rate is adjusted periodically, typically at intervals of 30, 60 or 90 days.
Because the coupon rate floats with the current market rate, floating-rate notes exhibit minimal price sensitivity to changes in interest rate levels. Thus, they offer some protection against unexpected inflation. The benefits of this instrument seem to blind investors to its drawbacks.
Trading Term Risk for Default Risk
Floating-rate loans most commonly serve as an alternative source of financing for companies whose credit quality is rated below investment grade. Loans that carry below-investment-grade ratings are typically referred to as either high-yield or junk. Thus, they entail significant credit risk.
Unfortunately, credit risk tends to show up at exactly the wrong time: when equities are getting hit as well. In other words, just when you require the bonds in your portfolio to provide shelter from the storm—as Treasuries typically do—the risks of corporate loans show up in the fixed income you’re holding and both 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%, underperforming the Barclays Capital U.S. Aggregate Bond Index by 34%—not exactly the safe haven that bonds are supposed to be. A second negative can be high costs. The average asset-weighted expense ratio for floating-rate mutual funds and ETFs is about 0.9%.
Let’s look at what’s inside these funds to see why you shouldn’t consider investing in them. To start, floating-rate note funds purchase corporate loans from banks. Keep in mind that companies with the strongest credit don’t need to go to banks. They typically get their funding directly from the capital markets. So, typically, you won’t be investing in investment-grade credit this way.
That means that even though your investment is not an equity investment, it will have a significant amount of equity-like risk. And the problem is that you’re not being appropriately compensated for that risk. The bank, for instance, 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 ratios. For example, the DWS Floating Rate Plus Fund (DFRAX), with $1.4 billion in assets as of January 28, 2016, carries a sales load of 2.75% and has an expense ratio of 1.06%.
The result is that investors are taking all of the credit risk without receiving anything near the market’s required return. What’s more, the “Plus” in the fund’s name could well apply to the amount of credit risk that investors are taking. The fund has a credit makeup of 3% BBB (the lowest investment grade), 26% BB (speculative), 62% B (very speculative) and 9% below B (extremely speculative), of which 5% is not even rated.
The credit quality is reflected in the highly negative correlation between annual changes in the option-adjusted spread (OAS) of the Barclays U.S. Corporate Bond Index (a very common measurement of U.S. credit risk) and the 12-month rolling returns of the floating-rate benchmark. This strong inverse relationship reflects the tendency of floating-rate fund returns to move in the opposite direction of credit spreads. Given this relationship, it shouldn’t come as a surprise that DFRAX lost 28.1% in 2008—reflecting both the nature of its credit risk and the equity-like nature of that risk.
As another example, we’ll take a look at the PowerShares Senior Loan Portfolio ETF (BKLN), with $3.8 billion in assets. The good news is that the fund’s expense ratio is “just” 0.65%. Its credit quality is also somewhat better than DFRAX: 14% of its portfolio is BBB, 44% is BB, 29% is B and 11% is below B, with 5% of that unrated.
Equity Risk in Disguise
We can see the equity-like nature of the risk associated with floating-rate note funds by looking at the correlation of their returns to various asset classes. Vanguard observed that for the period from February 1992 through June 2013, the correlation of returns on floating-rate notes to both short-term and long-term Treasuries was -0.3. On the other hand, the correlation to high-yield corporate debt was 0.74 and 0.44 to the U.S. equity market. Said another way, floating-rate notes are a lot like junk bonds and a lot more similar to stocks than Treasury bonds.
The recent failure of the Third Avenue Focused Credit Fund to provide liquidity for its investors highlighted yet another risk in floating-rate note funds, specifically the risk that something could occur which may trigger a significant liquidity event for these securities, creating downward pricing pressure and problems for investors seeking redemptions.
The authors of a February 2015 article, Floating-Rate Bonds Revisited: The New ’Old Maid?’, cite a Moody’s report that warns: “Bank loan mutual funds, and ETFs in particular, have a structural mismatch between the cash settlement of the assets they hold and their liabilities to fund investors. In stressed market conditions, redemptions typically increase, potentially leading to scenarios where funds would be unable to return cash from the proceeds of fund investments to their investors within the typical cash settlement period.” The report adds that settlement times for bank loans “typically range from 15 to 25 days.”
The authors further note that “Industry research firms like Moody’s are not the only organizations calling attention to possible liquidity dangers with FRBs. The Securities and Exchange Commission (SEC) launched a review of mutual fund liquidity, seeking in part to gauge the potential risk of FRB funds.” They go on to quote SEC Chairwoman Mary Jo White, who said: “A fund that does not manage liquidity risk in its portfolio could have difficulty meeting redemptions if it came under stress.”
The authors point out that another problem for floating-rate funds is that commercial banks can no longer act as the liquidity providers they were in the past. They don’t have the capacity, not even on corporate and high-yield bonds.
The Bottom Line
Floating-rate funds do minimize interest rate sensitivity. And at times they have outperformed fixed-rate debt during periods of rising interest rates. It remains important to note, however, 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 make the mistake of thinking that floating-rate note funds are substitutes for money market accounts or other high-quality, short-term investments. However, they do entail significant credit risk.
Therefore, investors should view these funds as they would high-yield (junk) bond funds and not as an alternative to high-credit-quality bond holdings. Add the heightened liquidity risk to the equation and I’m led to conclude that these funds should be avoided.