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Portfolio Fix: For Retirement Income, Floating Rate Bond Funds?

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For most current and soon-to-be retirees, generating income in retirement is an all-consuming question. Typical asset allocation strategies advocate the shift from equity-based “growth” securities during working years to fixed-income assets that generate a steady stream of payments on which retirees can depend. With the yield on the benchmark 10-year Treasury note now fixed at a rather unappealing (and taxable!) 3.2%, the current value of traditional fixed-income investments as a tool to finance what could be several decades of retirement is an open question.

Furthermore, with the warning signs of inflation flashing bright red—oil at $110 a barrel and gold at more than $1,500 an ounce—it could even be that fixed income investments will deliver a negative total return in the years ahead, hardly a reassuring prospect for a retiree seeking a secure source of income.

One way of coping with this problem that has so far stayed under the mass market investment radar is a floating rate bond fund. With U.S. interest rates following a downward trend for roughly the past two decades, these funds have understandably failed to generate much investor interest. With rates now having seemingly nowhere to go but up, and a notable lack of attractive alternatives, floating rate bond funds are one of the few, if not the only, fixed-income funds that will provide larger yields if interest rates rise.

There are two types of floating rate bond funds. One invests in high quality, investment grade floating rate notes issued by banks and other financial services companies. Their holdings tend to be fairly short in maturity, often less than three years. Others invest in bank loans made to sub-investment grade companies, and hold securities with longer maturities and higher yields.

There are roughly two dozen distinct floating rate bond funds available to U.S. investors, as well as two exchange traded funds. The largest and one of the least expensive of these funds—the Fidelity Floating Rate High Income Fund (FFRHX)—is not especially large as far as bond funds go, with about $6.3 billion in assets, according to company data. As of March 31, 2011 it had 546 different holdings of mostly “BB”- or “B”-rated floating rate notes, with 13.6% in the health care sector and 8.1% in the information technology (IT) sector. The weighted average maturity of its portfolio was 3.6 years and it had a 30-day yield of 2.7% on May 3.

Performance among these funds over the past three years has varied widely, from a low of about 2.9% average annual total return, to a high of 8.1% delivered by the Eaton Vance Floating-Rate Advantage Fund (EAFAX), which is the oldest floating rate bond fund, having opened for business in 1989. It has about $1.7 billion in assets and offered a 30-day yield


of 4.2% as of April 30. Like the Fidelity fund, the vast majority of its holdings are sub-investment grade floating rate notes rated “BB” or “B” from the health care or IT sector. The average maturity of its 409 holdings was 4.4 years.

Sensing that investor interest in floating rate bond funds may be about to grow, PIMCO announced this month that it is opening the PIMCO Senior Floating Rate Fund (PSRIX) as a companion to its $3 billion PIMCO Floating Income Fund (PFIAX) that opened in 2004. “The $600 billion market for bank loans is an important source of attractive spreads and diversification, potentially enhancing yields in a low interest-rate environment and better preparing portfolios for a rise in rates,” said portfolio manager Beth MacLean in announcing the fund’s launch.

Investors who prefer exchange traded funds (ETFs) can now not only invest in the floating rate note market, but even have a choice of funds. In April, the Market Vectors Investment Grade Floating Rate ETF (FLTR) made its debut with about $5 million in assets invested in floating rate notes issued by banks. Its 24 holdings had an average of 2.75 years to maturity. It follows by about a month the launch of the PowerShares Senior Loan Portfolio (BKLN), which owns about $120 million in sub-investment grade bank loans. Its 113 holdings had an average of 4.45 years to maturity and its 30 yield was 3.8% on May 4.

S&P Senior Editorial Manager Vaughan Scully can be reached at [email protected]. Send him your ideas for mutual fund and ETF stories.


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