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Friday, November 11, 2011

Floating Rate Funds attractive, you decide

In a market of prevailing low interest rates investors returns are humble, often way below what they have enjoyed in the heyday and without any doubt, the yields experienced during the lead up to the 2008 credit crisis. 

It is an economic conundrum or balancing act where on one side of the coin pun intended, central banks lower interest rates to stimulate borrowing but on the other side, that doesn't fair well with investors that are looking for high yields from the risks they take. When interest rates drop at the source or risk free rate, they drop across the board.

One irony is that of Asset Backed Securities. In effect what brought the credit crisis on is also assisting investors escape its deflationary grips and floating rate funds are becoming fashionable, well they were quite exciting before the August market rout.

Floating Rate Funds
Floating Rate Funds are part of the asset backed security class often presented to investors in the form of a floating rate mutual fund because the single investment by itself comes as a  large ticket cost. These types of funds are primarily attractive to the fixed income investor and differ from other typical bonds in the simple fact that their rate of return floats. So if an investor was to buy a fixed rate bond today, they will loose out at an opportunity level when interest rates climb. Now we know interest rates generally climb as the economy recovers from a recession because central banks need to tighten these rates to prevent inflation.

From an interest risk perspective, floating rate funds are less sensitive to the price/yield relationship that impacts other bonds and it is that which makes them less price volatile when interest rates change. In effect, the investor can move on or off the structure without taking large losses and they may also benefit from increased returns when the central bank lifts the base or prime rate.

On the downside, floating rate notes may help the investor but now the borrower suffers as interest rates rise. This is sad but true and someone always seems to be on the loosing end with the way these things go. From the borrower's perspective repayments increase as interest rates do and so does the obligor's default factor. To solve this problem and to keep the investors keen, the investor is compensated for this additional feature of credit risk by enhancing the floating rate investment with an even higher yield. In many cases, these marginal returns can be well above the norm set for other typical fixed income investments and make our Floating Rate Fund really appetizing. In short, if the economy stabilizes and defaults don't rise, then these instruments might be a good investment to consider.

Specific Funds
There are a couple of funds we have taken a peep at here which are being actively sold on the market and have a substantiated track record.

Pioneer Multi-Asset Floating Rate Fund
Pioneer believes "now, more than ever, floating rate securities can play an important role in an investor’s total asset allocation." and, they quote the following key reasons below which summarize the appeal clearly.
1-Protection against rising rates unlike other types of fixed income securities whose rates are fixed, the income component of floating rate securities rises.
2-A hedge against inflation and income potential can help investors protect purchasing power overtime.
3-Low correlations to other fixed income asset classes may help investors diversify their credit portfolio, as a further cushion against volatility.
All points are very valid and floating rate funds generally pay a much higher yield than normal bond issues. They are also safer in general than corporate bonds because they are not subordinated and in many cases come fully collateralized so that recovery rates at point of default are positive. 

More can be found on the Pioneer fund by clicking this link 

Eaton Vance Floating-Rate Fund
The interview between Reuters and Scott Page is particularly insightful and explains how the fund has been performing over the year of 2011.

Eaton Vance - Floating Rate Fund
 More can be found by following this link

There are of course some interesting points to note from Scotts comments which are: 

The cumulative defaults in the portfolio have been between 12% and 14% which have resulted in a Loss Given Default (that includes recovery) of 4% to 5%. This is encouraging to say the least and with spreads on potential deals being 5% or greater in comparison with treasury bonds, investors will satisfy a positive return even if the losses continue at this rate.

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