Industry risk rating failing investors of floating rate note funds

Floating rate note (FRN) funds are gaining in popularity because of their marketed ‘promise’ to protect capital during periods of rising interest rates.  In Canada since the mid-2000s, FRN funds invest mainly in corporate loans bearing a fluctuating interest rate.  They appeal to investors who fear rising interest rates – which is most – but offer competitive current yields.

Investors seduced by this class of funds should be aware that hedging one risk often heightens exposure to other risks.  And standard industry risk ratings fail to communicate this trade-off, which risks significantly understating these funds’ true risk exposure.

Floating Rate Notes

FRNs are issued mainly by corporations and, to a lesser extent, governments.  Rather than a fixed rate of interest, FRN issuers (i.e. the borrowers) pay an interest rate equal to some benchmark interest rate like treasury bills or LIBOR (London Interbank Offering Rate) plus some premium.

Banks are major issuers of FRNs, which may be partly explained by the growth in consumers’ variable rate borrowing (e.g., variable rate mortgages).  Accordingly, banks may offset this variable revenue stream with debt obligations with similar characteristics.  This kind of matching makes sense.

While FRNs offer protection against rising rates, the largely-corporate profile of FRN issuers (including a good proportion of below-investment grade companies) means that FRN fund investors are assuming a good deal of credit risk.  A significant but less concerning risk is the falling returns that would result in a falling interest rate environment.

These risks are not reflected in fund risk ratings in Fund Facts disclosure documents.

FRN Fund Risk Ratings

Each fund’s prospectus and Fund Facts disclosure document contain a risk rating.  The table below shows a summary of the existing group of FRN funds along with associated risk ratings and trailing commission rates.  (Click on the below table to enlarge it.)

Two things stand out from this table.  First, risk ratings vary quite a bit for a pretty similar group of products.  Most risk ratings cluster in the middle of the range.  Second, fees and commissions are even more diverse than the funds’ risk ratings.

Standouts include Renaissance, which offers the highest trailing commissions among this group; and O’Leary which sports the lowest risk rating and among the highest commissions.

But these risk ratings are striking in the face of the return history of this asset class.

Historical Downside Risk

Two Canadian FRN funds have been around long enough to experience a bear market.  And both funds suffered significant downside as shown by calendar year returns for both the Trimark and BMO FRN funds.  Bear market losses just a few years ago were more equity-like than of the variety normally associated with lower risk investments.

Trimark Floating Rate Income fund lost 27% of its value during the financial crisis – significant but not insurmountable.  The fund has fully recovered, having long surpassed its previous peak.  But BMO Floating Rate Income fund is different story.

BMO’s fund lost nearly half of its value – more than many stock funds – and remains under water as of August 31.  Its previous peak is more than seven years into the past.  It’s no surprise that BMO Floating Rate Income sports the highest risk rating of its peers.

But it’s a general failing of the industry’s accepted risk rating method that “medium risk” is equated with losing half of your money and waiting the better part of a decade to recover.  This critique applies to most funds, not just FRN funds.

O’Leary Funds serves as another interesting example.  While its two-page Q&A document serves as a sales brochure for its new FRN fund, it includes more than 20 years of FRN index history – which shows a 29% loss for calendar 2008.  But its risk rating is based on the index performance over the past three years – a very bullish environment for all forms of fixed income before this spring.

Industry Risk Ratings Need Improvement

My critique of the fund industry’s approved risk rating method is not new.  Six years ago – before the worst of the financial crisis – I took the industry to task for its meaningless risk and suitability ratings.  Then as now, Fund Facts’ oversimplification of these two ultra-important factors does not tell investors what simple numbers can clearly communicate.

Fund sponsors should use sufficient history (of the fund or its benchmark) to include at least one bear market in assessing a fund’s risk rating for investor disclosure documents.  Investors may not immediately comprehend credit spreads and spread compression.  But they understand losing money – and that’s what the industry should be showing them before they invest.