Get 3% With Low Risk Via Floating-Rate Bond Funds

Wary investors have fallen in love with floating-rate bond funds. And no wonder: The funds pay a decent yield—typically about 3%, sometimes more—and are designed to protect against rising interest rates, which just about everyone expects once the Federal Reserve determines that it really is time to dial back its stimulative policies.

See Also: A Juiced-Up Junk Bond Fund

While most kinds of bonds struggled over the past year, floating-rate funds produced impressive gains. According to Morningstar, the average floating-rate fund delivered a total return of 5.9%, trouncing Barclays U.S. Aggregate Bond index by some seven percentage points. But those generous returns suggest that the funds are not risk-free, so it pays to be selective when choosing one. (All performance figures are as of November 1.)

How they work. Floating-rate bond funds invest in loans that banks make to companies. The rates on the loans are tied to a short-term benchmark, such as the London Interbank Offered Rate, or LIBOR, and generally reset every 30 to 90 days. As a result, if interest rates go up, the loans adjust quickly, preserving their value. (For most other kinds of bonds, prices move in the opposite direction of interest rates.)

But here's the downside: Companies that take out these loans tend to have poor credit and are likelier to default than higher-quality borrowers. Also, because the bank-loan market is relatively small, heavy selling can result in exaggerated losses. That's what happened in 2008. Floating-rate bond funds fell by an average of 30%, as investors ran for cover during the financial crisis.

The floating-rate market has grown since then, but it's still a good idea to choose a fund that keeps risk in check. Demand has increased the supply of loans lately and eased lending standards. "You're starting to see looser restrictions on companies," says Morningstar analyst Sarah Bush. She recommends funds that invest mostly in bank loans rated single- or double-B (the latter being the highest "junk" bond rating). Avoid funds with high expenses—that is, anything above the category average of 1.2% annually. Their managers may be tempted to reach for yield to overcome the drag of high fees.

Two good no-load options are Fidelity Floating Rate High Income (FFRHX) and T. Rowe Price Floating Rate (PRFRX). Both have 30-day yields of about 3%. They are also relatively cheap. The Fidelity fund's annual expense ratio is 0.71%; Price charges 0.86%. Over the past year, the funds returned 4.2% and 4.5%, respectively, compared with 5.9% for the average bank-loan fund. The underperformance in a strong market for bank-loan funds isn't surprising, because the Fidelity and Price funds focus on higher-quality loans and so take fewer risks than their typical rivals.

Another way to cut expenses is to consider an exchange-traded fund such as PowerShares Senior Loan Port­folio (BKLN). The ETF, which charges 0.66% per year, aims to match the performance of an index of the 100 largest bank loans available. That focus should make it easier to trade the loans, helping to minimize volatility. The fund yields 4.1%, and it returned 4.8% over the past year.

If you can stomach more risk for a chance at bigger yields, consider a closed-end fund. CEFs are traded on an exchange, the same way ETFs are. But because CEFs are structured differently, their share prices often differ dramatically from the value of their underlying assets.

Consider Nuveen Floating Rate Income (JFR), a closed-end fund that, at a price of $12, trades at a 5% discount to the value of its assets. Like most closed-end bond funds, Nuveen borrows money to boost yield; at last report, it had borrowed about 30% of its assets. The fund returned just 1.4% over the past year, but thanks to leverage, its current yield is a whopping 6.8%.