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Floating rate funds may provide shelter from rising rates

Many investors have concluded that higher inflation rates are imminent due to the high levels of debt the government has assumed to combat the financial crisis of 2008. For this reason Treasury Inflation Protected Securities have been gaining popularity. These are bonds which can produce an increased interest yield if the rate of inflation rises.

I’m personally not so sure that high rates of inflation are on the way and certainly not expecting an inflation problem in the very near future. Inflation is usually caused by demand — too many dollars chasing too few goods. At present and for the foreseeable future, demand has been slack due to the high unemployment rate and the newfound conservative fiscal perspective that most American families seem to have adopted.

Whether inflation rears its ugly head is a question which will be answered in time. However, I think there is a much better chance we will see interest rates rise moderately over the next several years for a couple reasons, even if inflation does not run rampant:

1. The Federal Reserve will likely start to raise its target for the federal funds rate from recent historically low levels and return to more normal levels in the next couple years as the economy continues to improve.

2. The large amount of government bond issuance expected in the coming years as many countries finance their growing deficits and entitlement programs will likely force market interest rates higher.

Another category of fixed income security may fare better than Treasury Inflation Protected Securities, in my opinion. “Floating rate” securities are bonds, generally issued by corporations, which have the interest yield tied to the prime rate or some other interest rate index. As the prime rate rises, the borrower has to pay more in interest to the owner of the bonds. Because the interest payments rise and fall with the general level of rates, there is less impact on the value of these securities due to interest rate fluctuations.

This is one category of investment where I highly recommend use of a mutual fund to obtain diversification to reduce risk and also the expertise of a manager who understands the pricing of these types of securities. Many mutual fund families offer a floating rate fund as part of their lineup.

Of course, your next question should be “Tom, what can go wrong?” Asking what can go wrong should be a higher priority than what can go right.

If interest rates fall, the yield on these bonds goes down, and your income level is less. I believe this is an unlikely scenario at present, but it is still a risk.

The second and more significant risk is “issuer default.” Since these bonds represent loans made to corporations, failure of the borrowing corporation to make the interest and principal payments would represent a large risk to the bonds’ value.

Total loss in a default situation is unlikely because these bonds have “senior” standing in a bankruptcy proceeding, so recovery of 50–70 percent of principal value would be likely. Default risk is the primary reason I think use of a mutual fund to access this asset class is a great idea.

Floating rate securities make some sense in the investment climate we foresee, and in appropriate amounts may have a place in your portfolio.

Tom Breiter, president of Breiter Capital Management Inc. and a registered investment adviser, can be reached at (941) 778-1900.

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