This fund invests in bonds and other fixed-income investments whose interest rates are not fixed. When interest rates are low, investors on fixed incomes look for unconventional and often risky methods to make money to supplement their standard of living. Therein lies the attraction of the floating-rate mutual funds to both investors and mutual fund firms. Read on to discover more about floating-rate equity funds and some things to remember before you take a bite.

What Is a Floating-Rate Fund?

Financial products that pay a variable or interest rate can be found in floating rate funds. An ETF or mutual fund that invests in bonds and debt instruments whereby interest payments fluctuate with the level of the underlying interest rate is known as a variable rate fund. On the other hand, fixed-rate investments fall behind the market when interest rates climb. Investors should expect a more predictable interest income from floating rate funds when interest rates rise.

Floating-Rate Fund Operation: A Quick Guide

Floating-rate funds can be made up of various investments, even though there is no formula for calculating a floating-rate fund. One-month to five-year-term loans and corporate bonds are all examples of floating-rate investments. In addition to corporate loans and mortgages, funds that fluctuate in value include those with a floating interest rate.

Banks lend to businesses at a variable interest rate known as a floating rate. Sometimes, these loans are repackaged and sold to investors in a mutual fund. In the same way that mortgage-backed securities are packaged mortgages that investors may purchase into and obtain an overall rate of return from the various mortgage rates in a fund, floating-rate loans are comparable.

What Can You Learn from a Floating-Rate Fund?

Compared to a fund or instrument with a fixed payout or set bond coupon, a floating-rate fund has a lesser sensitivity to interest rate swings. In a rising interest rate environment, floating-rate funds attract investors, as the fund will pay out a more significant amount of interest or coupon.

Bonds and loans can be held in a floating rate fund, as can other kinds of variable rate debt. Different goals are set for the various credit funds that are administered. Credit quality and duration are two possible targets for strategy.

Floating-Rate Loans 101

You should know the basics of floating-rate loans before investing in floating-rate funds. A floating-rate loan is a variable-rate loan issued by a financial institution to a company that is often deemed poor credit. Syndicated or senior bank loans are also known as this type of loan.

Recapitalization, debt refinancing, and acquisitions are common reasons for these loans to be taken out by borrowers. The interest rate on these loans is referred to as "floating rate" because it fluctuates depending on generally established reference rates, such as the London Interbank Offered Rate, plus a specified credit spread over the reference rate, regularly, usually every 30 to 90 days.

Floating-Rate Fund Characteristics to Look for

Graduation to Junk-Status

Floating-rate funds should be considered a more risky portion of your investment portfolio since they typically invest in the debt of low-credit-quality borrowers. Credit risk compensation will make up most of the funds' earnings.

Floating-rate loans have historically had more excellent default recovery rates than high-yield bonds, which has resulted in fewer credit losses for investors. A varied portfolio of floating-rate loans should do well in an improving economy with tighter credit spreads.

Time Restriction

With a floating-rate mutual fund's NAV, short-term borrowing rates should impact the fund's value less than other types of mutual funds, such as long-term bonds. Every 30-90 days, changes in the reference rate will affect the interest rate on most floating-rate loans, which typically have a seven-year term.

That's why most fixed-rate investments are more susceptible to fluctuations in short-term borrowing rates than floating-rate ones. Because of this, income investors are drawn to floating-rate funds during periods of economic recovery and rising short-term borrowing rates.

Niche Market Diversification

Investing in income through a floating-rate fund can help investors diversify their portfolios. Most main asset classes are not highly correlated with floating-rate loans because they are constructed in a way that makes them distinct from other types of loans. The price correlations of floating-rate loans and hazardous asset classes have been observed to converge during moments of financial market stress.

The Verdict

During low-interest rate conditions, investors may be tempted to take on additional risk to get a higher rate of return. Income-producing products, such as floating-rate funds are becoming increasingly popular, and investors should be aware of their basic concepts. Income investors can benefit from diversification and protection against interest rate risk by investing in floating-rate funds. If you're looking for a different strategy to boost the yield on your portfolio, consider these investments.