The issue is even more critical as a wave of Baby Boomers retire and seek income-producing investments to replace earnings from employment. Now, the tea leaves of Federal Reserve minutes appear to imply that the central bank expects to raise short-term rates later this year.
Bonds trading at low yields, of course, are highly susceptible to interest rate increases. Bonds have fixed-interest payments, so when interest rates rise, the trading prices of the securities decline in order to increase their yields. The decline in principal can be substantial and, at times, exceed the stream of income that the securities provide, resulting in the asset class generating negative returns.
With that in mind, some advisors are considering floating rate funds to hedge against the impact of rising interest rates. The funds invest in bonds that are backed by floating rate loans, which are a source of financing for businesses with low credit ratings. Interest rates on the loans are established as a spread above an underlying gauge, such as the London Interbank Offered Rate, the Fed Funds rate or the prime rate.
Importantly, the interest rates on the loans reset as the rates on underlying gauges change. Some loans will reset as often as every two weeks, but others may reset only annually. The beauty of floating rate debt is that the reset feature keeps yields on the bonds consistent with the interest rate environment, so investors don’t have to sell the securities at a discount when rates rise.
Because of that feature, funds that invest in floating rate loans tend to outperform traditional bonds when interest rates climb. That’s because the trading prices of traditional bonds decline as interest rates climb, unlike the prices of floating rate bonds. In addition, the reset feature means that floating rate bonds have a negative correlation to Treasury securities. According to Boglehead.org, the debt has a -0.29 correlation to short term Treasuries, for example, and only a 0.28 correlation to corporate bonds.
Yet, advisors seeking to hedge interest rate risk need to remember that floating rate bonds have a higher risk of default than traditional bonds, even though the debt is considered senior. Floating rate debt is typically rated below investment grade, a reflection of the credit rate of corporations that use the form of financing.
With that in mind, the funds are a tradeoff: they may help manage interest rate risk but they increase investors’ exposure to default risk. It’s important to note that the funds also underperform traditional bonds when interest rates decline.
Traditional bonds will have yields and interest rate payments that reflect the interest rate environment. When rates start to decline, longer-term bonds will have locked in the higher rates, so they will trade at premiums, unlike floating rate bonds that will have interest rates reset to reflect declines in interest rates.
Indeed, in some cases, the excess returns that floating rate bond funds generate as interest rates climb will be surrendered when interest rates decline. Since few, if any, investors can accurately predict interest rates, it’s highly unlikely that trying to time the market by selling the funds when rates peak will be successful. Liquidity can also be an issue for the floating rate debt and funds as declining interest rates can cause investors to flee from the asset class.
When considering those shortcomings, advisors may want to think twice about hedging risks by making large allocations to the funds. That is especially true when considering that many bond investors are risk averse, so trading off interest rate risk for increased default risk may not be appealing. Instead, it may makes senses to view floating rate funds as another tool to improve portfolio diversification. Indeed, in a prior white paper, Vanguard argues that the funds may be appropriate as part of a diversified allocation to fixed income assets rather than as an alternative to traditional bonds.