Floating Rate Loans

AS INVESTORS HAVE sought both higher yields and protection against rising interest rates, some have turned to floating rate funds, also known as bank-loan or leveraged-loan funds. Examples include ETFs such as Invesco Senior Loan ETF and SPDR Blackstone Senior Loan ETF, and mutual funds like Fidelity Floating Rate High Income Fund. There are also closed-end funds that focus on bank loans, many of which use leverage to goose their yield.

The loans held by these funds have their rates pegged to short-term interest rates. That means you aren’t locked in at current yields, which is the danger faced by those owning regular fixed-rate bonds. But while bank-loan funds may be a good defense against rising interest rates, you could suffer if the economy turns down.

The reason: The loans involved are typically made to companies that are rated below investment grade. Because they’re less financially strong, the risk of default is higher. In the event of a bankruptcy, bank loans typically have seniority over other debt, so holders are more likely to get their money back. Still, buyers of bank-loan funds should be prepared for a rough ride. How rough? In 2008, the funds lost almost 30%, according to Morningstar. The funds also struggled during 2022 and early 2020, though losses were tiny compared to 2008.

Next: International Bonds

Previous: Junk Bonds