Many types of mutual funds are primarily designed to pay income to investors in various forms. Some income funds invest in bonds. while others derive income from mortgages or stocks that pay dividends. such as utility and preferred offerings.

Another class of income fund also exists: the floating rate fund, also known as a prime rate fund, bank loan fund, or loan participation fund. Floating rate funds are one of the newer types of income funds to appear on the market and have gained quite a following in recent years.

What Is a Floating Rate Fund?

Most floating rate funds invest primarily in senior secured loans that are made by banks and other lending institutions to companies that are experiencing financial turmoil. These funds are riskier by nature than some other types of income funds, like those that invest in treasury securities or governmental agency issues, such as Ginnie Mae. However, the loans the funds invest in are typically backed by some or all of the companys assets as collateral and are among the first obligations satisfied if the company should become insolvent.

Floating rate funds pay a variable rate of interest that closely matches a benchmark rate, such as the Prime Rate or LIBOR (London Interbank Rate).

History of Floating Rate Funds

Floating rate funds were introduced in the 1980s as an alternative to riskier offerings, such as junk bond funds. Their popularity grew the following decade as many major mutual fund companies added this type of fund into their families.

But public sentiment cooled somewhat at the turn of the century, as many funds experienced a sudden and rather unexpected drop in share price when the U.S. government instituted mandatory third-party pricing on all prime and floating rate funds. This happened because the fund companies were using methods of loan valuation that showed the values of the loans to be slightly greater than they actually were, and these methods also differed from one company to another. Therefore, the SEC  stepped in and standardized this process under federal securities laws.

Because the governmental method of determining the share prices of these funds was somewhat different than that of many of the fund companies, the prices were summarily adjusted downward by as much as several cents a share in some cases, resulting in a markedly lower return on capital for investors at that time.

Advantages of Floating Rate Funds

Floating rate funds are superior to other types of bond funds and guaranteed investments in some respects. These unique funds can benefit investors in the following ways:

1. Higher Yield. Floating rate funds often have yields that can exceed those of CDs and other safe investments  by as much as 2%. This can be an important difference for investors who depend upon income from their portfolio to pay their monthly bills.
2. Price Stability. The share prices of these funds tend to remain relatively stable because they do not invest in bonds. This means that the prices of the underlying securities in the fund portfolios will not fluctuate in response to changes in interest rates like bonds do, as they are floating rate instruments tied to current rates. Prime rate funds can, in fact, be looked at as hedges against changes in interest rates for this reason.
3. Moderate Risk. Although prime rate funds are riskier than guaranteed instruments, their risk is usually lower than that of equity or junk bond funds. Prime rate funds invest in senior secured loans, which are among the first to be repaid if the borrowing company goes bankrupt. Senior secured lenders will receive their money before any stock or bond holder, so the chances of recouping at least some money in the liquidation process is relatively high. The diversification within the funds portfolio also reduces the impact of any single default.

Disadvantages of Floating Rate Funds

Some of the disadvantages of floating rate funds include:

1. Limited Liquidity. Most floating rate funds only allow investors to redeem their shares once a month at most. Many others only allow redemptions once per quarter, and in some cases it is not possible to take money out at all for at least the first year. Greater liquidity also usually means a slightly lower yield.
2. Expenses. There may be a sales charge assessed for any redemption that is made within a certain period of time after purchase, possibly from one to three years. Many floating rate funds also have fairly high annual expense ratios relative to bond funds, and this reduces the payout for the investor.
3. Leverage. Many floating rate funds use leverage in their portfolios, which means that they borrow money to purchase additional loans and thus achieve a higher return. However, this can cut both ways, because leverage amplifies losses as well as gains. If a fund borrows money to purchase a loan that defaults, this has a doubly negative impact because in addition to the loss from the default, the fund must pay off the interest on the margin loan used to buy the defaulted loan.

Suitability of Prime Rate Funds

Although they are riskier by nature than money market funds or CDs, even conservative investors who need income should seriously consider these funds for at least a portion of their portfolios, as they have always paid a competitive rate of interest with moderate volatility.

Those who need a high degree of liquidity are obviously not appropriate candidates for these funds, but longer-term investors can enjoy the higher yields and additional diversification that floating rate funds can provide.

Corporations with large cash balances can also look to these funds as means of improving the yields in their cash accounts. However, ultra-conservative investors who cannot absorb any type of market loss should probably seek safer avenues of income (such as CDs) instead.

Examples of Floating Rate Funds

Several major mutual fund families offer funds that invest in senior secured loans. Some of the more well-known floating rate funds include:

• Eaton Vance Floating Rate & High Income Fund (EVFHX). This fund has closely mirrored the returns posted by its underlying benchmark index, the S&P Leveraged Loan Index. The fund has annual expenses of 1.11% and has averaged just over 4% per year after expenses over the past 10 years, but a whopping 21% over the past 3 years (2009 to 2011). The fund has a maximum 2.25% sales charge.
• Invesco Prime Income Trust (XPITX). This fund has a performance record similar to that of Eaton Vances fund, but has higher fees, with an annual expense ratio of 1.55% and a maximum 3% sales charge.
• Fidelity Advisor Floating Rate High Income Fund (FFRAX). This funds performance slightly lags behind the abovementioned funds in performance, but also has slightly lower fees, with an annual expense ratio of 1.03% and a maximum sales charge of 2.75%.
• Putnam Floating Rate Income Fund (PFLRX). This fund does not have as long a track record as the other funds listed here, but the one- and five-year returns are comparable to those of Eaton Vance and Invesco. This fund does have somewhat lower expenses as well, with a maximum sales charge of just 1% and annual fees of about 1% as well.

Prime rate funds are offered by brokers, financial planners, investment advisors, and banks, as well as directly from the fund companies. The minimum amount required to purchase a floating rate fund will vary from one fund family to another; some funds will allow a minimum initial purchase of $250, while others require a larger amount, such as $1,000. These thresholds are generally uniform for all funds within a given family.

Final Word

Floating rate funds have grown to occupy an important niche in the fixed-income arena, and can provide superior yields with relative price stability for moderate and aggressive investors. These funds can lower the volatility of a bond portfolio and can also provide additional diversification beyond that of traditional fixed-income offerings.

For more information on prime and floating rate funds, consult your financial advisor .