The perils of floating-rate funds

  @FortuneMagazine November 21, 2013: 7:38 AM ET
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(Fortune)

The allure of investments with floating rates is undeniable. The world expects interest rates to rise, and who wants to be caught with low-fixed-rate bonds when that happens? Predictably, investors have flooded into a new crop of ETFs and mutual funds that hold floating-rate debt, with assets surging from $69.6 billion to $120.3 billion over the past 12 months, according to Vanguard. But the investments can be risky, as we'll see.

The theory behind floating-rate funds is sound. Unlike fixed-rate bonds, whose prices fall when interest rates rise, "floating" rates move in tandem with Libor or the Federal funds rate, reducing the impact of rising rates.

It's hard to assess the performance of these ETFs, since the most venerable of them is just two years old. But the Credit Suisse Leveraged Loan Index gives an encouraging hint. Since its inception in 1992, the floating-rate loan index outperformed fixed-income benchmarks by 4.3% in the three periods in which the Federal Reserve increased interest rates, according to a Vanguard study.

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