SamMamudi

An earlier version of this story misspelled a fund manager’s name. It has been corrected.

NEW YORK (MarketWatch) — For investors convinced that today’s ultralow interest rates are bound to rise, specialized bond funds that adjust to fluctuating market conditions might seem tailor-made.

After all, conventional bond funds typically will lose value when interest rates climb, since a bond’s price and yield moves in opposite directions. So-called floating-rate funds, as their name implies, have more flexibility. They invest primarily in debt securities that don’t have fixed interest payouts, protecting shareholders against the threats to principal that other bond funds might suffer.

But there’s a danger with these funds that may outweigh their appeal: Their low credit quality means they’re not for the faint-hearted.

Rather than holding debt from high-grade companies, floating-rate funds mostly invest in bank loans made to, or bonds issued by, companies with low-credit quality, and these portfolios usually sport average credit ratings well below the definition of junk.

Low clouds

A review of the funds that investment researcher Morningstar Inc.’s includes in its bank-loan category, and for which it has credit-quality data, shows none rated higher than BB. The credit risk is a red flag for conservative investors who may find floating-rate funds appealing as a way to stay in bonds even as interest rates rise.

And though their managers argue that these funds’ holdings are superior to junk bonds because bank loans are higher up the credit structure, investors still should consider the low credit quality before jumping in.

The past two calendar years illustrate floating-rate funds’ volatility. In 2008, they lost an average 27% according to Standard & Poor’s Equity Research. High-yield bond funds, meanwhile, lost 26% while short-term bond funds fell 3.4%. In 2009, floating-rate funds were up 41%, while high-yield funds rose 47% and short-term bond funds gained 9.5%.

That schizophrenic performance profile should make clear that bank-loan investments are a bad idea for bond investors who value stability of principal above all else — the risk is simply too great, wrote Christine Benz, director of personal finance at Morningstar, in a research note earlier this year.

Interested investors will want to build a position slowly, to protect [themselves] in case current projections about the economy’s rebound are overly rosy, she said.

Also, consider expenses. Floating-rate funds are more expensive than most of their fixed-income counterparts. S&P data shows the category’s average expense ratio is 1.3%, compared to 1.26% for high-yield funds, 0.95% for intermediate investment-grade funds and 0.9% for short-term bond funds. No one MarketWatch spoke to could give a definitive explanation, except to suggest that administrative costs of investing in bank loans raised fund prices.

Performance versus promise

Some might choose to ignore past performance and focus on future promise. While deflation may be an immediate threat, in the coming years the U.S. is likely to see rising inflation and interest rates. If that does happen, investors who’ve been fleeing to bond funds recently may see losses. See related story about the looming danger for bond funds.

Floating-rate funds won’t face that problem. That’s because their rates reset, between every 30 and 90 days depending on the security, usually in line with the London Interbank Offering Rate, or LIBOR. This means their rates will climb along with the market.

Meanwhile, the managers of these funds downplay concerns about credit risk.