Rick Welch - Floating Rate Securities
At its March meeting the Federal Reserve, as widely expected, raised its benchmark interest rate by 0.25%, the sixth such increase since the bank cut its rate to nearly zero during the 2008 financial crisis. The Fed remains on track to continue with gradual interest rate hikes projecting two more hikes this year, followed by three additional hikes in both 2019 and 2020. For fixed income investors, the expectation of higher rates brings with it the need for a tighter focus on how their fixed income portfolio allocation is constructed. Of primary concern is increased interest rate risk, which is the risk of falling bond prices due to a rise in market interest rates (remember price and yield are inversely related). In periods of rising rates, many investors look to alternative fixed income assets like floating rate securities (or floaters) which offer protection against rising interest rates and can reduce the rate sensitivity of their bond portfolio. Floaters have very low effective duration (which measures the sensitivity of a bond’s price to changes in interest rates) that is typically close to their reset frequency. Adding floaters can also provide additional bond portfolio diversification as they have low correlation with corporate bonds (0.35) and negative correlation with government bonds (-0.45).
Floaters are defined “as securities whose stated interest rate floats or adjusts (resets) periodically based on a predetermined benchmark. Once the benchmark is determined (examples include Prime Rate or LIBOR), the issuer will establish an additional spread that it is willing to pay in excess of the benchmark rate.” Most floaters use the three-month LIBOR rate which means they pay interest and have the coupon rate reset on a quarterly basis. Many floaters are issued with either a cap (maximum interest rate the issuer will pay regardless of benchmark rate movement), a floor (minimum) or both. The key difference between floaters and fixed-rate bonds is how each investment type reacts to movements in market rates. A floating rate security tends to maintain its value, with less price fluctuation, if rates rise whereas a fixed-rate bond of similar maturity will lose value.
Floating rate securities come in many different forms. For ease of explanation we will divide the universe into two parts: investment grade floaters and bank loans. A portfolio of investment grade floaters would provide exposure to corporate bonds, agency and non-agency mortgage securities, adjustable-rate mortgages and Treasuries. Investment grade floaters offer two key benefits, which are rate coupons that adjust upward as short-term interest rates rise and relative price stability. The trade off here is that floaters typically pay lower interest rates than fixed-rate bonds do. On the opposite end of the risk spectrum is bank loans, which have become increasingly popular over the past several years. Bank loans are similar to high yield bonds in that both security types offer investors higher yields in exchange for taking on greater credit risk. The majority of securities held by bank loan funds are rated BB (speculative grade) or lower. Most bank loans are senior secured notes which means they sit higher in a company’s capital structure than unsecured high yield debt and have historically had higher recovery outcomes in default or restructuring events. Like high yield debt, bank loans are not suitable for all investors. We view bank loans not as a core fixed income holding, but rather as a hedge against monetary tightening that can reduce interest rate sensitivity and improve diversification within a portfolio of investment grade fixed-rate bonds.