A Floating Rate Fund Favorite

07/30/2013 9:00 am EST

Focus: STRATEGIES

Mark Salzinger

Editor and Publisher, The No-Load Fund Investor

While rising interest rates have hurt the prices of most types of bonds, floating rate bonds and notes have largely held their ground, observes Mark Salzinger of The Investor's ETF Report.

Floating rate debt (also called bank loans, senior loans, or leveraged loans) differs from conventional, plain vanilla bonds in how the rates of their interest payments are set.

Most conventional bonds are issued with a fixed rate. When rates rise, prices fall for fixed rate bonds. Floating rate debt, however, exposes investors to virtually no interest rate risk.

The interest payments reset at frequent, fixed intervals, usually less than every 90 days. The issuer agrees to pay a premium, called the 'spread,' above the interest rate of a market benchmark, often the London Interbank Offer Rate (LIBOR).

As the benchmark rate rises, the issuer will pay more interest at the next reset. As the rate declines, so will the interest payment.

Of course, floating rate securities are subject to credit risk. Such securities are popular among issuers with poor credit ratings, because it allows them to borrow at rates lower than what they would have to pay if they issued conventional fixed-rate debt.

To counter the risk in lending to such borrowers, most floating rate securities give lenders a senior position in the borrower's credit structure. That is, they are high in the pecking order of creditors to be repaid, should the borrower default.

It is possible to think of floating rate ETFs that invest in high-quality bonds as a kind of prime money market fund with somewhat more risk.

We think PowerShares Senior Loan (BKLN), the largest floating-rate ETF by assets, is the most attractive option for investors interested in adding a floating rate ETF to their portfolio. Its SEC yield was recently 4.3%. Its expense ratio is 0.66%.

BKLN has had a high correlation with fixed-rate high-yield bonds. This reflects the generally strong credit in recent years, but when such issuers struggle, floating rate bonds do too.

BKLN has more than $4.7 billion in assets, as of June 28. It tracks an index of the 100 largest outstanding leveraged loans, all of which must have at least one year to maturity and a spread of at least 1.25 percentage points above their benchmark rate.

Nearly 85% of BKLN's portfolio is in securities rated 'BB' or 'B,' the two highest tiers of below-investment-grade ratings. About 45% of the portfolio is in securities with one-to-five years to maturity; the other 55% is in securities with five-to-ten years to maturity.

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