Floating-Rate Loan Funds

Floating-rate loan funds have garnered a significant share of assets and attention during the past year. These funds invest in loans extended by financial institutions to entities of below investment-grade credit quality. They are sometimes called "leveraged" loans because companies that are extended these high interest loans usually have a significant level of debt relative to equity. Funds that invest in floating-rate loans may be appealing products to investors seeking greater returns because, in order to compensate lenders for taking on additional credit risk, the loans' yields tend to be higher than investment grade bonds.

As their name implies, the interest rates on floating-rate loans adjust by a pre-determined spread over a reference rate, like the London Interbank Offered Rate (LIBOR). Funds that invest in floating-rate loans may be attractive in a low or rising interest rate environment because, in addition to having higher yields, the floating rate feature allows the fund's interest rate to increase when rates rise. This is because the underlying interest rate on most floating-rate loans reset after a relatively short period of time, like 30, 60 or 90 days.

Unlike traditional fixed-income bonds, the market for floating-rate loans is largely unregulated and the loans do not trade on an organized exchange, making them relatively illiquid and difficult to value. Funds that invest in floating-rate loans may be marketed as products that are less vulnerable to interest rate fluctuations and offer inflation protection, when in fact the underlying loans held in the fund are subject to significant credit, valuation and liquidity risk.