Interest rates on floating-rate loans, essentially IOUs that banks make to borrowers with below-investment-grade ratings, are tied to a short-term benchmark and reset every 30 to 90 days. That makes these loans a good place to be if interest rates rise. You earn a decent yield because of the lower quality of the borrowers. But the loans tend to be less volatile than junk bonds because banks have priority over other lenders should the borrower default and because the frequent interest-rate resets protect the lender from a rise in rates.
What could go wrong: The bank loan market is relatively small, so if investors get spooked, bank loans can suffer. In 2008, the average floating-rate bond fund dropped 30%. Looking ahead, bank loan returns will likely be anemic if the Federal Reserve continues to put off raising short-term rates. And most bank loans have a rate “floor,” or a minimum interest rate. So even if short-term rates rise, it could take a few rate hikes by the Fed before floating-rate loans see the benefit, says Anthony Valeri, a strategist at LPL Financial, a brokerage.
How to play them: This category is best left to professionals. Uncertainty about the Fed may lead investors to pull money out of bank loans, so stick with loans of high quality. Our favorite bank-loan fund is Fidelity Floating Rate High Income (FFRHX). The fund mostly holds loans rated double-B or single-B, the two highest tiers of junk bond territory. It charges 0.69% annually and yields 4.0%.
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