Interest rates have moved up this year but are still near historic lows. This is especially true at the front end of the yield curve where people are basically earning nothing on their savings, money market, and even short-term CD accounts (and even losing money net of inflation). Demand from yield-starved investors and the opportunistic nature of financial firms has brought attention to “money market alternatives” like floating rate funds.
Floating rate funds
Floating rate funds are baskets of short-term debt instruments. The instruments are typically less than three years in maturity and often even less than one year. The short-term nature of the instruments means the funds are liquid. Something unique about floating rate funds is that the interest rates on the instruments adjust at predetermined intervals. In other words, as market interest rates rise, the rates on the instruments can also rise. This reduces the interest rate risk for the investor and also reduces the price sensitivity, or duration, of the fund’s holdings. At the same time, these funds pay higher yields than money market accounts (some funds as high as 1%).
No free lunch
While that all sounds attractive, investors should remember that there really are no free lunches when it comes to investing. Sure, floating rate funds pay higher yields, but that’s because they are riskier than traditional money market funds.
For example, some funds are comprised of short-term “floating-rate notes” that are non-investment grade bank loans (i.e. low credit quality and high risk). When times are good, the loans perform and fund prices are stable. However, when credit markets freeze up, the loans can fail and the funds can take large and sudden losses.
Of course, there are also some funds that hold higher quality collateral, like short-term “floating rate bonds.” The bonds are typically investment grade and due to the higher credit quality, such funds have less price volatility. However, they also pay lower yields – again there’s no free lunch.
The bottom line
There may always be higher-yielding alternatives to savings accounts, but those alternatives simply don’t always provide the same level of safety. If the cash you have on hand has a purpose, like for living expenses, a purchase, or for emergencies, then safety (not yield) should be the primary concern. In that case, it doesn’t make sense to reach for yield in the first place. If you’ve determined that it’s appropriate to reach for yield, just be sure to understand what you’re investing in, and that “free lunches” (or free yields) aren’t what they seem.
Victor K. Lai, CFA
This blog is for informational purposes only. Nothing on this blog represents advice. Investing is inherently risky and involves the potential for loss. Victor Lai does not own any of the securities referenced in this posting. Clients of Bellwether Capital Management LLC may own shares of the securities referenced in this posting.