Advisors need to be careful with floating rate funds

A Windsor-based advisor warns due diligence on the part of planners could avoid another ABCP-like disaster.

Advisors need to be careful with floating rate funds
Bay Street has been quick to answer the challenge posed by the current period of weirdly ultra-low rates. New products designed to deal with this interest rate risk have been come to the marketplace. One of these options, so-called floating rate funds promise is to preserve capital through coming rate rises.

But one Windsor-based advisor warns planners need to do their own due diligence on these complex, opaque funds.  

So-called floating rate funds are one of the relatively new products Bay Street has brought onto the market as a way of dealing with this low-rate environment. These funds compile various debt instruments into a security. Many invest in corporate loans that carry a fluctuating interest rate. The promise is that they are expected to preserve capital in an era in which interest rates could rise.

But Dylan Brown, a certified financial planner with Brown & Associates in Windsor Ontario, suggests advisors need to be careful with these funds. Advisors need to do their own due diligence and sit down, to see what these securities are holding. "I've been doing this for 15-20 years. And I wonder what's in these things. If I was going with a floating rate bond, it is perceived as low risk because we want to minimize the risk. But I want to investigate this stuff. I wonder if we're just getting packaged, non-investment grade debt the banks are getting off their books and selling it out to various funds,” says Brown.

His worry is that banks have been off-loading sub-investment grade debt to fund companies. As rates have lowered, terms on debt have become looser. Junky debt has become junkier. Covenants on debt are loosening. This is similar to the environment just before the meltdown in 2008 when Canadian asset-backed commercial paper securities ended up loaded with masses of extremely badly written debt. Could something similar happen again? Brown wonders what has ended up in some of the floating rate funds now on the market. 

“My concern is…What's in this stuff? We have to investigate for our clients. This is our job," says Brown.

Others have raised similar concerns about the viability of these funds. Possible proof is that some of these funds have not performed as they were supposed to. When the Fed last warned about stemming its stimulus program some of these Canadian funds (advertised as a way to protect capital through rate changes) actually plunged in terms of value.

The moral of the story, of course, don't rely on the banks and fund companies to do your work--the role of a financial advisor is to sort through this stuff and figure out what's good and what's not.Or, to put it another way, don’t let your clients get caught up in the next ABCP scandal.