As interest rates rise, investors may look to floating-rate funds

The appeal of floating-rate loans usually peaks when interest rates are rising. But they may help diversify portfolios in any environment. 

What are floating-rate loans?

Floating-rate loans are designed with interest rates that adjust to market rates. They are a form of debt financing typically negotiated between a group of banks and a corporation and often extended to companies with higher levels of debt compared to cash flow, carrying a greater credit risk than investment-grade bonds. While floating-rate loans are below investment-grade (or below BBB-) quality, they’re higher up on the capital structure and secured by the issuer’s assets so they have higher recovery rates in the event of a default.

But unlike traditional bonds, floating-rate loans don’t make a fixed-interest payment, or coupon, each period.

Instead, their coupons reset every 30 or 90 days, floating up or down with the changes in prevailing interest rates. This floating feature makes loan prices less sensitive to shifts in interest rates, so flows into floating-rate loan funds tend to increase when the Federal Reserve is actively raising rates in response to a growing economy and improved labor market. And, as you can guess, this trend tends to reverse when rates are falling. 

How can investors access floating-rate loans?

Investors can buy individual floating-rate bonds through a broker, or they can invest in floating-rate loan mutual funds that invest only in floating-rate securities.

Why floating-rate loans can be a good diversifier in any interest-rate environment

Historically, floating-rate loans have outperformed in rising and flat interest-rate environments. When rates are rising, the median annual return for floating-rate loans, as gauged by the Credit Suisse Leveraged Loan Index, has exceeded the return on U.S. Treasuries and the Bloomberg U.S. Aggregate Bond Index by more than 6 percentage points (see chart below). But what’s possibly overlooked is that floating-rate loans have also delivered attractive absolute and relative performance regardless of the broader interest-rate environment. Because yield is such a significant component of total return, floating-rate loans also have outperformed U.S. Treasuries and the Bloomberg Aggregate Bond Index when rates are flat. It’s only when rates fall that we have seen floating-rate loans underperform.

These figures are shown for illustrative purposes only and are not guaranteed. They do not reflect taxes or investment/product fees or expenses, which would reduce the figures shown here. Past performance is not a guarantee of future results.

Although their interest-rate-related benefits are what drive investors’ flows into and out of the asset class, floating-rate loans can help diversify a portfolio at any time — and this benefit can be overlooked. Most of the return in floating-rate loans comes from their exposure to credit risk (exposure to corporations), while the Bloomberg U.S. Aggregate Bond Index gets most of its return from duration risk (interest-rate sensitivity). So, historically they’ve had low correlation to each other and behave differently in different market environments. 

The best time to invest in floating-rate loans

Typically, the best time to invest in floating-rate loans is when credit fundamentals (i.e., economic growth, and corporate growth and profits) are positive and when interest rates are low and expected to rise.

Bottom line 

Floating-rate funds are popular when interest rates are rising, but they may have diversification benefits in any interest rate environment. In addition, they may offer an attractive level of income, can protect against price deterioration during inflation and when interest rates rise, and may help reduce overall portfolio volatility. Diversification does not assure a profit or protect against loss.

If you’re wondering whether a floating-rate fund may complement your portfolio, contact your Ameriprise financial advisor. They can provide recommendations specific to your unique financial situation.