Every time interest rates are low, investors begin to make mistakes — engaging in activities that they otherwise wouldn’t undertake — such as stretching for yield by taking on credit risk — if rates were at more normal levels like 4 or 5 percent. With Treasury yields having been at extremely low levels for several years now, and money market accounts paying virtually nothing, many investors haven’t been able to resist the siren call of higher yields, especially if they can get them without taking term risk (the risk of rising interest rates). Unfortunately, they often forget that yield and return aren’t synonymous.

In addition to the search for incremental yield, concerns over the potential for rising interest rates have led many to seek alternative ways to protect against a rise in interest rates, without sacrificing yield. The dual concerns have led many investors to consider floating-rate bond funds (also known as bank loans). Over the 12 months ended June 30, 2013, assets in floating-rate funds rose by more than 70 percent, from about $70 billion to about $120 billion.

How Rates Are Set

Interest payments of floating-rate notes are determined based on a floating reference rate — such as LIBOR (the London Interbank Offered Rate) — plus a fixed spread. Depending on the loan agreement, the rate is adjusted periodically, typically at intervals of 30, 60 or 90 days. Because the coupon rate floats with the current market rate, floating-rate notes exhibit minimal price sensitivity to changes in interest rate levels. Thus, they offer some protection against unexpected inflation. The benefits seem to blind investors to the negatives.

Trading Term Risk for Default Risk

Floating-rate loans most commonly serve as an alternative source of financing for companies whose credit quality is rated below investment grade. Loans that carry below investment grade ratings are typically referred to as either high yield or junk. Thus, they entail significant credit risk. Unfortunately, credit risk tends to show up at exactly the wrong time, when equities are getting hit as well. In other words, just when you need the bonds in your portfolio to provide shelter from the storm — as Treasuries typically do — the risks of corporate loans show up and both your stocks and bonds are hit at the same time. This is exactly what happened in 2008 when floating-rate funds averaged losses of 29 percent, underperforming the Barclays Capital U.S. Aggregate Bond Index by 34 percent — not exactly the safe haven bonds are supposed to be. A second negative can be high costs. The average asset-weighted expense ratio for floating rate mutual funds and ETFs is about 0.9 percent.

Peeking Inside

Let’s look at what’s inside these funds to see why you shouldn’t consider investing in them. Floating-rate note funds purchase corporate loans from banks. Keep in mind that companies with the strongest credits don’t need to go to banks. They typically get their funding directly from the capital markets. So you won’t typically be investing in investment grade credits. That means that while your investment is not an equity investment, it will have a significant amount of equity-like risk. And the problem is that you’re not being appropriately compensated for the risks. The reasons are that the bank may not be passing on the full credit spread and the funds are taking a big cut of the spread in the form of their expense ratio. For example, The DWS Floating Rate Plus Fund, (DFRAX ), with $3.2 billion in assets as of December 2, 2013, carries a sales load of 2.75 percent and has an expense ratio of 1.09 percent.

The result is that investors are taking all of the credit risk, but not receiving anywhere near the market’s required return. And the Plus in the fund’s name could well apply to the amount of credit risk investors are taking. The fund has a credit make up of: BBB 1 percent (the lowest investment grade), BB 33 percent (speculative), B 57 percent (very speculative), and 9 percent that is less than B (extremely speculative), of which 6 percent is not even rated. (Data provided by Morningstar.) The credit quality is reflected in the -0.9 correlation between annual changes in the option-adjusted spread (OAS) of the Barclays U.S. Corporate Bond Index — a common measurement of U.S. credit risk — and the 12-month rolling returns of the floating-rate benchmark. This strong inverse relationship reflects the tendency of floating-rate fund returns to move in the opposite direction of credit spreads. Given this relationship it shouldn’t come as a surprise that DFRAX lost 28.1 percent in 2008 — reflecting both the nature of its credit risk, and the equity-like nature of that risk. As another example, we’ll take a look at the PowerShares Senior Loan Portfolio ETF (NYSEARCA:BKLN ), with $6.2 billion of assets. The good news is that its expense ratio is just 0.66 percent. The bad news is that its credit quality is even worse than that of DFRAX — 3 percent of its portfolio is BBB, 35 percent is BB, 34 percent is B, and 20 percent is below B, with 13 percent being unrated.

Equity Risk in Disguise

We can see the equity-like nature of the risks of floating-rate note funds by looking at the correlations of their returns to various asset classes. For the period February 1992-June 2013, the correlation of returns on floating-rate notes to both short-term and long-term Treasuries was -0.3. On the other hand, the correlation to high-yield corporate debt was 0.74, and it was 0.44 to the U.S. equity market. In other words, floating-rate notes are a lot like junk bonds and a lot more like stocks than Treasury bonds.

Summary

Floating-rate funds do minimize interest rate sensitivity. And they have outperformed fixed rate debt during periods of rising interest rates. However, it’s important to note that significant portions, if not all, of the excess returns earned during rising-rate periods would have been lost if investors were unable to successfully time their exits. And the evidence demonstrates that investors engaging in such tactical allocation strategies are unlikely to be successful.

The minimization of interest rate sensitivity causes some investors to make the mistake of thinking that they are substitutes for money market accounts or other high-quality short-term investments. However, they do entail significant credit risk. Therefore, investors should view these funds as they would high-yield (junk) bond funds and not as an alternative to high-credit-quality bond holdings.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.