Strubel Investment Management's Dumb Investment of the Week for this week is floating rate note funds. I recently was working with a retired client who wanted an income-generating portfolio and who had become frustrated with the overly aggressive approach of a previous financial advisor. The client had requested of the advisor for one account, "Just put me in something safe that earns 2% a year." Instead, the advisor placed the client in a floating rate note fund (the Eaton Vance Floating-Rate Note Fund)!
You may wonder what floating rate notes are, and what makes them so bad.
What Are Floating Rate Notes?
Floating rate notes are bonds that have a variable coupon. A traditional bond has a fixed coupon. For example, a newly issued 10-year treasury bond might have a par value of $1,000 and pay a fixed coupon of $27.50 per year (since treasuries pay semi-annually, you would get two checks for $13.75) for a yield of 2.75%. A floating rate note works differently. First, most floating rate notes pay interest quarterly. Second, the amount of interest paid varies, hence the floating rate name. The interest paid is usually based on some reference rate, such as LIBOR plus a certain fixed spread. For example, a note might pay USD 3 month LIBOR plus .5% each quarter. That means a floating rate note with a par value of $1,000 would pay .25% (USD 3 month LIBOR) + .75% (the fixed spread) or $10. If LIBOR stayed the same for the entire year, then the bond would pay $40 in interest or 4%. If LIBOR moved up, then the coupon payments would increase. If LIBOR fell, then the coupon payments would fall.
Since the interest paid by the bond increases when interest rates rise, investors are not taking on any interest rate risk in a rising rate environment. With interest rates at very low levels, investors are also not taking on much (although there is some) risk that interest rates will fall substantially. The floating part of floating rate notes isn't the part that makes it a dumb investment.
What Makes Floating Rate Notes Dumb?
What makes floating rate funds dumb investments is the underlying credit quality of the firms that issue floating rate notes. A majority of floating rate notes are corporate loans originated by banks to less-than-credit-worthy customers. Companies with investment grade credit ratings can easily access the capital markets and issue traditional bonds to investors. Companies with below investment grade credit or no credit rating at all find it much more difficult to issue traditional bonds, so they approach banks, which then sell off the debt to investors. Think about it. A company with good credit can lock in low rates for an extended period of time using traditional debt instruments, so why would they want to take on interest rate risk by issuing floating rate notes? It's usually only the desperate borrowers who need low interest payments now and who are willing to risk increasing rates in the future. It's either issue high yield debt or roll the dice on interest rates and take on floating rate debt.
Indeed, this raises another question. If the borrowers using floating rate notes are dicey credit risks, then how likely are they to be able to make higher interest payments if interest rates rise? Typically, rising interest rates occur when the economy is improving, so this may not be a big red flag but it is something that investors need to consider.
The Eaton Vance Floating-Rate Note Fund (MUTF:EVBLX)
To examine the issue more closely, let's look at the fund that was sold to my client: the Eaton Vance Floating-Rate Note Fund.
First off, we can understand why floating rate note funds may be appealing to investors. The fund has an SEC 30-day yield of 3.19% versus a generic investment grade bond fund like the Vanguard Total Bond Market Index Fund (NYSEARCA:BND), which has an SEC 30-day yield of just 2.28%.
The problems start when we look at the credit quality. A safe, conservative, 2% investment this is not! Only 2.52% of the securities held by the fund are investment grade. The rest are junk, including 6.25% that are rated CCC or not rated at all.
All images sourced from Eaton Vance.
With such dismal credit quality, it's unlikely that the fund will perform well during market downturns, which are when you are looking to your safer investments (such as bonds) to cushion the volatility in your portfolio.
In fact, the first thing you may notice when looking at the chart below is the fund's returns in 2008. Remember that the stock market (the S&P 500) was down 37% in 2008.
The fund was down 30.41%, but it wasn't just this fund that did poorly. The S&P/LSTA Leverage Loan Index was down almost 30% as well.
Investors in floating rate note funds are simply purchasing bond funds that tend to mirror the stock market.
Long-Term Performance Is Lacking
Maybe the performance of these funds somehow justifies their existence. Investors might be willing to stomach the ups and downs of the funds for higher returns. With this fund at least, that doesn't seem to be the case. The fund had average annual returns of 4.1%, or 3.86% if you include the maximum sales charge over the past 10 years.
By contrast, the index that the Vanguard Total Bond Market Fund tracks had average annual returns of 4.64% over the past 10 years. Vanguard funds do a good job of tracking the index, so you would expect the fund to have tracked the index within 15 or so basis points as it had over the 3- and 5-year periods.
Indeed, despite this particular floating rate fund's underperformance, it doesn't appear the S&P/LTSA Leveraged Loan Index did much better. It returned 5.24% on average per annum, which is only about 50 basis points higher than the much safer and less volatile index the Vanguard ETF tracks. Floating rate note funds promise a dubious premium for the risks investors take.
What Should Investors Do?
If floating rate notes don't make good investments, then what can investors who are looking for high income or protection from inflation do? I'll share the solution I came up with for my clients and then go over some other possibilities as well.
After talking with the client about needs, risk tolerances, and the previous situation, I discovered two major issues. First, the client needed more income than just 2% from the portfolio; and, second, the 2% comment was a response born of frustration with that previous advisor and not what the client actually wanted from me.
Rather than reaching for yield by investing in junk bonds, floating rate note funds, or other dubious investments, we split the portfolio into two parts. We will invest some of the money in stocks in our dividend portfolio (investors could also look at some of the dividend ETFs we profiled in an earlier article that actually pay above average dividends) and some in safer investment grade bond funds.
The portion invested in our dividend portfolio is in high quality stocks that pay above average dividends. The term "high quality" has been bandied about lately when talking about stocks. While I could go into detail about the returns on capital and profit margins of all the companies in the portfolio, I took a novel approach and built a chart of the credit rating of the stocks. Now, obviously, stocks are not bonds, but looking at how the debt market views a company can be helpful, especially when trying to quantify the term "high quality."
Below are the credit ratings for all 22 stocks in our dividend portfolio.
9 (8) 
 Using S&P rating Lockheed Martin is A.
 Using S&P rating Lockheed Martin is A.
As you can see, every stock we own is viewed as investment grade by the debt market. We also have a fairly even distribution of companies, with 9 at the lower end of investment grade and 13 at the upper ends of investment grade.
The stock investment portion of the portfolio provides us with the same opportunity for returns that are higher than investment grade bonds (which floating rate funds frequently advertise), while also providing a measure of inflation protection. For instance, we have substantial investments in tobacco companies, which have the pricing power needed to raise prices in an inflationary environment.
But stocks are riskier then bonds, so to temper this risk we will place the other portion of the money in investment grade bond ETFs, such as the Vanguard Total Bond Market ETF and the iShares Barclays Treasury Inflation Protected Securities ETF (NYSEARCA:TIP). This investment gives us an allocation to safe assets that can help cushion the portfolio during market downturns. We also allocated some money toward Treasury Inflation Protected Securities, which will again provide some measure of protection if interest rates head up. (Note: TIPS coupons are adjusted based on changes in CPI; however, the Fed typically raises interest rates in an attempt to counteract rising inflation so the two typically move together, although not always.)
With the dividend portfolio yielding around 4% and BND having a 30-day SEC yield of 2.28%, a simple 50/50 split between stocks and bonds would give us a portfolio yield of 3.14% (4%/2 + 2.28%/2). This is right in line with the 3.19% yield of the Eaton Vance fund but with much less expected volatility and in my opinion less risk.
Other Potential Alternatives
I believe a combination of high quality dividend paying stocks and traditional investment grade bonds or bond funds is the best way for investors to increase the income of their portfolios, and a far superior risk adjusted portfolio than a floating rate note fund.
If investors insist on putting money into floating rate note funds, they should take a look at several low cost ETFs that invest mainly in investment grade floating rate notes. The iShares Floating Rate Note Fund (NYSEARCA:FLOT), SPDR Barclays Capital Investment Grade Floating Rate Fund (NYSEARCA:FLRN), and the Market Vectors Investment Grade Floating Rate Fund (NYSEARCA:FLTR) all invest primarily in investment grade floating rate debt.
Additionally, the US Treasury also started issuing floating rate treasury notes last month. Investors can purchase them directly through the US government by opening an account at TreasuryDirect.gov.
Disclosure: I am long BND, TIP, LMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.