Variable-Rate Investments Can Buoy Your Portfolio
Bank-loan funds and ETFs aren't the only interest-paying securities whose distributions vary with interest rates.
Variable-rate bank-loan funds, such as Fidelity Floating Rate High Income (symbol FFRHX, yield 3.7%) and Eaton Vance Floating Rate (EABLX, 3.8%), have delivered positive returns while the broad bond market has been in a funk. I enthusiastically recommend them—at least for now. The category delivers 4% yields with less risk of price pressure from rising rates (yields and prices move in opposite directions) than most mainstream income investments. That’s because these funds hold short-term loans with interest rates that adjust with changes in market rates. And with Federal Reserve chairman Jerome Powell explicit about the Fed’s intention to pump short-term rates higher in 2018 and 2019, the funds’ payouts are surely headed up. (Returns and yields are as of June 15.)
But the loans are overwhelmingly junk-rated, and bank loans will be one of the first debt categories to suffer principal losses once economic growth abates and assorted commercial and industrial borrowers feel pressure. Besides, bank-loan funds and exchange-traded funds are not the only interest-paying securities whose distributions vary with interest rates. I therefore suggest you supplement floating-rate loans with other variable-rate investments now. When trouble arrives, it’s better to be early than to be too late.
Skip some of the heavily marketed alternatives. That includes TFLO, the iShares Treasury Floating Rate Bond ETF, and USFR, a similar ETF from WisdomTree. The funds mainly hold two-year Treasury floaters. Their yield of just over 1.5% trails ordinary two-year T-notes and resets only quarterly.
Instead, start with a simple money market mutual fund. These funds pass along Fed-influenced higher rates immediately. With the yield curve so flat (meaning that short- and intermediate-term rates are close to 10- and 30-year yields), a money fund is a legitimate variable-rate investment, especially if you choose one that pays nearer to 2% than the category’s average 30-day yield of 1.4%. Look first at the money fund attached to your brokerage account, or consider Vanguard Prime (VPMCX, 2%).
To get closer to that 4% from the bank loans, consider Wall Street’s pipeline of unusual, overlooked or institutional-style variable-rate debt offerings. These are high-quality investments priced to pay a premium over the benchmark 30-day or 90-day London Interbank Offered Rate, or LIBOR, index (the three-month is currently at 2.3%), backed by assets such as commercial mortgages on top-shelf office towers.
For example, RiverPark Floating Rate CMBS Fund (RCRIX, 4%) owns slices of floating-rate mortgages on trophy-type office buildings and hotels in New York City, Chicago and Philadelphia and resorts in Florida and Hawaii. The fund’s monthly distribution will reflect increases in LIBOR. RiverPark made the portfolio a public fund in October 2016, and it has not had a single monthly loss; a Bloomberg Barclays index of commercial mortgage securities shows eight losses over the same period.
The venerable FPA New Income Fund (FPNIX, 3%) is a melange of car loans, variable-rate mortgage securities and other good stuff with an average life of only two years. The fund’s yield is up a half point since the end of 2017.
You can look at any bond or income fund’s holdings to see if most of their assets are floating-rate. That’s not yet a litmus test for funds that I recommend.
But I note that Ares Capital (ARCC, 9.1%), which provides financing to small and midsize businesses, prides itself on borrowing on fixed terms but extending credit and choosing portfolio investments that earn floating or adjustable rates. It returned 11.6% for the year to mid June. All things being equal, a floating rate feature is insurance against both the Fed and inflation, and a fine source of income, too.