The perils of floating-rate funds

November 21, 2013, 12:38 PM UTC
Illustration: ALEX NABAUM

The allure of investments with floating rates is undeniable. The world expects interest rates to rise, and who wants to be caught with low-fixed-rate bonds when that happens? Predictably, investors have flooded into a new crop of ETFs and mutual funds that hold floating-rate debt, with assets surging from $69.6 billion to $120.3 billion over the past 12 months, according to Vanguard. But the investments can be risky, as we’ll see.

The theory behind floating-rate funds is sound. Unlike fixed-rate bonds, whose prices fall when interest rates rise, “floating” rates move in tandem with Libor or the Federal funds rate, reducing the impact of rising rates.

It’s hard to assess the performance of these ETFs, since the most venerable of them is just two years old. But the Credit Suisse Leveraged Loan Index gives an encouraging hint. Since its inception in 1992, the floating-rate loan index outperformed fixed-income benchmarks by 4.3% in the three periods in which the Federal Reserve increased interest rates, according to a Vanguard study.

That’s the good news. The bad news is that the ETFs’ performance can be volatile and risky. Many funds, such as Invesco’s PowerShares Senior Loan Portfolio, buy “speculative grade” debt. It’s a simple equation, as always: You get a higher interest rate in exchange for greater risk. Indeed, the current average yield to maturity on Invesco’s fund is about 5.5%. Such funds can be great bets when the economy is booming. From 2004 to 2007, speculative-grade default rates hovered at 2% or less, according to S&P Global Fixed Income Research. But if trouble comes, lower-quality debt tends to get hammered. In 2009 the category had a 9.5% default rate, vs. 0.3% for investment-grade.

A safer option is to consider a fund such as BlackRock’s iShares Floating Rate Bond ETF, which holds investment-grade debt. The yield — 0.5% — is significantly less than those of funds with lower-quality debt. But if a financial storm comes, investment-grade debt tends to fare noticeably better. In 2008, for example, the index that BlackRock’s ETF is tracking fell by about 10%, compared with a 33% decline in the Dow Jones industrial average and almost 30% for floating-rate funds similar to Invesco’s ETF, according to Vanguard.

As a result, investors should pay close attention to timing. A continued U.S. recovery is far from a sure thing. The higher-quality-debt funds can provide some protection against interest rates while also offering a cushion in the event of a rapid downturn. For now that may be a better idea.

This story is from the December 09, 2013 issue of Fortune.