If one is looking for a relatively safe return, another area to explore are the so called floating rate funds. These are funds that invest in corporate debt that adjusts as the market interest rate rises or falls. Usually, this debt is of a much shorter term than a regular corporate bond. This tends to reduce the level of risk. Further, because the interest rate on the loan varies somewhat with the market, the risk of rising rates is greatly reduced.
Let me take a moment to explain why rising rates are a risk. For those of you with experience in bond investing, you will already know this. On a regular corporate bond, the rate paid by the company is fixed for a term like thirty years. If interest rates rise in the market, the only way for the rate on the corporate bond to rise is for the price of the bond to fall. A bond paying $50 or 5% on a thousand dollars of principal each year will rise to 5.5% if the price of the bond falls to $900. A major interest rate rise can take the price of long term bonds down substantially. There is a countervaling force which comes from the ultimate payoff of the bond being at $1000 while one is paying less, but for a thirty year bond, this is a small amount.
In any event, floating rate funds invest in debt for which the interest rate is not fixed. If the market rate rises, so does the rate on the floating rate funds. On the other hand, if the market rate falls, so does the rate on the floating rate funds. One of the things that makes the floating rate funds so attractive at the moment is the small likelihood that the market rate of interest will go any lower. Again, this is thanks to the Federal Reserve which has pushed interest rates about as low as they can possibly go.
Now you should be aware that the credit quality of the debt owned by the floating rate funds is usually not as good as the best corporate bonds. If there are a large number of bankruptcies, the floating rate funds could be hit. Nevertheless, the diversity of the investments reduces this risk to a more than manageable level. To put this in context, during the crash in 2008 and 2009, the floating rate funds declined by just about the same amount as both the junk bond funds and the investment grade bond funds. Of course, at the bottome of the market, the floating rate funds were still paying interest at a rate approaching 20%, a rate that normalized as the price of the fund rose quickly when the panic ended.
For me, the key to picking a floating rate fund is to find a management which has demonstrated skill over the past years. I like three different floating rate funds at the moment: Nuveen Senior Income Fund (symbol NSL), Nuveen Short Duration Credit Opportunities Fund (symbol JSD) and Invesco Van Kampen Dynamic Credit Opportunities Fund (symbol VTA). At the moment, NSL pays 7.23% return and is selling at a premium of 3.2%; JSD pays a return of 7.53% and is selling at a 1.97% premium; VTA pays 7.01% but it is selling at net asset value, i.e., no premium or discount. If I had to pick just one, it would be JSD because it is earning much more than it is currently paying out, so it looks like another increase in the payout is imminent.
It is important to remember that floating rate funds, like all of the areas the give off yield, are not a place to put all or even the majority of ones assets. They are just one of many places that make sense for yield investors. Right now, because of the current low rate environment, increasing this segment of investment would be a good move. Once rates actually begin to rise from their current depths, however, it will be time to start to cut back on these funds.
REMINDER: Before you invest in any of the funds listed here, please do your own research on the subject. I cannot begin to cover all of the important information that deals with each of these potential investments. You need to review these in more detail.
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