The ever-inventive securities industry has managed to package yet another type of loan into an investment product for small investors. Banks often make loans to large corporations and then syndicate them -- split them up -- and spread them out to other banks and investors to spread the risk. Recently, there have been a number of mutual funds formed to invest in these syndicated packages.
In most cases today, corporations borrow money with the agreement that the interest rate will be floating. A typical cost of money will be 2 percent above the prime rate, and since the prime rate is always floating, the interest rate paid by the borrower will typically be different from month to month. The prime rate, by the way, is the interest rate that banks charge their best customers.
For the lender, a floating rate removes the risk of making a loan at a fixed rate that will backfire if interest rates rise quickly. For many investors, the opportunity to invest in a loan whose interest rate will rise automatically with interest rates represents a better mousetrap. It beats investing in a fixed-interest bond whose capital value will drop if market interest rates rise. You're stuck taking the loss or holding on to the bond until it reaches maturity.
Bond mutual funds can be worse in that they don't offer the option of holding bonds to maturity. Instead, the fund owns thousands of bonds that are all reaching maturity at different times. The only option is to wait until interest rates stabilize, giving the fund time to replace all its maturing old low-interest-bearing bonds with new ones that pay the higher interest. At that point, the capital value of the fund will have recovered from its temporary downdraft.
With floating rate bank loan funds like the Fidelity Floating Rate High Income Fund (FFRHX), the anxiety stemming from possible capital reductions goes away. The interest paid by the borrowing will be tracking the market interest rates. If interest rates rise, nobody is stuck with old bonds at low interest rates. The interest moves up on all the bonds held by the fund.
Comparing the Fidelity floating rate investment product with, for example, Vanguard Short-Term Investment-Grade bond fund (VFSIX) offers a useful comparison for anyone searching for fixed-income investment products -- investments that involve little stock market or interest rate risk and that pay at least something. The difference between the two funds is that one changes interest rates on a monthly basis while the other has such short maturities that the effect of monthly changes is similar.
Fidelity's total percentage returns beginning in 2007 were 2.64, -16.47, 28.86, 7.81, 1.73, 6.80, and 2.09 so far this year. By comparison, Vanguard's Short-Term Investment-Grade fund generated the following results over the same period: 6.01, -4.61, 14.21, 5.37, 2.06, 4.66, and 0.42 so far this year.
A major spike in market interest rates is what everyone with bonds tends to fear, but the two funds cited here are reasonable antidotes to those who feel a need to preserve capital and generate as much interest as possible with a minimal exposure to possible capital loss.
Bear in mind that capital losses in bond funds are only temporary. How temporary is dependent on the average maturity of the bonds owned by the fund. If the average maturity is a long time, then the drop in capital value can persist for what might feel like an eternity. The funds described here offer some decent alternatives.
Stephen J. Butler is CEO of Pension Dynamics. Contact him at 925-956-0505, ext. 228 or firstname.lastname@example.org.