The Great Potential and Greater Risks of Prime Rate Funds

Prime rate funds have started to provide an alternative to the traditional mutual fund or CD as an investment. Prime rate funds are mutual funds that aim to mimic the prime rate and provide investors with a larger return on investment. Here are the basics of the primary fund and what you should consider before investing in them.

Prime Rate Funds

This type of fund is actually considered a closed-end mutual fund by design. Therefore, only a certain amount of investors can get involved before the doors are closed. This fund has the objective of trying to stay with the prime rate in the market. With this type of fund, the assets are not made up of your traditional forms of investment. Instead of buying stocks and bonds, these funds actually invest in floating rate loans. These loans have been made to corporations by commercial lenders and insurance companies.

In order to achieve the high interest rates that are necessary to copy the prime rate, they have to invest in loans that were made companies with less than perfect credit. These companies are charged a higher interest rate for the money that they need, which therefore provides a larger rate of return for investors. In order to qualify for these loans, the corporations had to secure them with some form of collateral. This may come in the form of accounts receivables, physical property, or some other form of collateral that they can use. This makes it a slightly safer investment, since it is backed by some type of collateral.

Pros

  • Senior debt: One of the major advantages of this type of investment is that the loans that make up the funds are considered senior debt. This means that in the event of bankruptcy, their debt will be satisfied first. These funds will be repaid before any other bondholders or creditors. This increases the likelihood that they will get their money back if the companies become insolvent.
  • Stable share price: Another advantage of this type of investment is that the share prices tend to remain somewhat constant. Yields can fluctuate based upon the short-term interest rate in the market. However, since this type of fund mirrors the prime rate, it will tend to go with the market. This can present you with a type of hedge as an investor.
  • Diversification: When investing in this type of fund, you can rest assured that the investments will be diversified. These types of funds typically hold many different loans in their portfolios. This means that the bankruptcy of one or two companies will not greatly impact the performance of the fund overall.

Cons

  • Liquidity: This type of investment does not carry with it very good liquidity. You may only be able to redeem your shares once a month or once every quarter.
  • High expenses: This type of fund also has higher than average expenses as compared to other types of mutual fund. While the returns will be better, you will have to pay a premium to get them.
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