Bond Insights | April 8, 2021

Rising Rates: When to Consider Floating-Rate Notes

Floating-rate notes can help lower a portfolio’s sensitivity to interest rate changes, but they aren’t necessarily the secret weapon to combat a rising-rate environment. Investors may want to consider floating-rate notes today, given general expectations that interest rates are likely to rise. However, if the Federal Reserve doesn’t raise short-term rates for a year or more—as is currently broadly expected—investors in floating-rate notes could miss out on the higher yields and higher income payments that short-term fixed-rate corporate bonds may offer. 

Why are floating-rate notes worth a look? They can help lower the average “duration” in a portfolio. Duration is a measure of interest rate sensitivity; the higher the duration, the greater the price decline when rates rise. The average duration for floating-rate notes is currently near zero. 

In our view, investors should continue to favor bond investments with low average durations to help limit the impact of rising Treasury yields on their portfolios, but there may be better options right now than floating-rate notes. Here’s what you should know.

The basics of floaters

Investment-grade floating-rate notes, or “floaters,” are a type of bond investment whose coupon payments are referenced to a short-term benchmark, like the three-month London Interbank Offered Rate (LIBOR). The coupons usually comprise the reference rate plus a “spread” meant to compensate investors for the potential default risk of lending to a corporation. Floater spreads tend to be relatively low, because the companies generally maintain investment-grade ratings.

The short-term reference rates tend to follow the lead of the federal funds rate, so floater coupon rates tend to rise and fall depending on whether the Fed is raising or lowering rates. More importantly, floater coupon rates do not fluctuate due to changes in other Treasury yields. The surge in the 10-year Treasury yield has made headlines all year, but that has had no impact to floater coupon rates.

Floater coupon rates tend to follow the lead of the federal funds rate

Since 2004, the short-term federal funds rate target and the Bloomberg Barclays U.S. Floating Rate Index have moved more or less in tandem.

Source: Bloomberg, using weekly data as of 4/2/2021. Bloomberg Barclays U.S. Floating Rate Note Index (BFRNTRUU Index) and U.S. Federal Funds Target Rate Mid Point of Range (FDTRMID). Past performance is no guarantee of future results.

Floaters can make sense in an environment when interest rates are rising, because their prices are not very sensitive to changing interest rates. For fixed-rated bond investments, prices and yields move in opposite directions. That’s a key reason why investors tend to be anxious about what a rising-interest-rate environment might mean for their bond holdings.

Floaters generally don’t exhibit that relationship. Because the coupon rate adjusts to shifts in short-term interest rates, their prices don’t need to. That results in prices that tend to be stable regardless of what Treasury yields are doing. However, floater prices can fluctuate, sometimes wildly, due to credit concerns. If the economic outlook deteriorates, floater prices can fall if corporations’ ability to service their debts declines.

Floaters or short-term fixed-rate bonds?

Investors can still consider floaters as short-duration investments today, but there may be better opportunities in the corporate bond market to earn higher yields and generate higher total returns even as we approach the first Fed rate hike of a new cycle. Here are a few considerations:

1. Floaters offer lower yields than fixed-rate corporate bonds with similar maturities. The average yield of the Bloomberg Barclays U.S. Floating-Rate Note Index is just 0.4%, compared to 1.0% for the Bloomberg Barclays U.S. Corporate 1-5 Year Bond Index.1 While neither yield is attractive in an absolute sense, the fact that the yield of the 1-5 year index is more than double the floater yield can’t be ignored.

The gap in coupon rates is even more stark, with short-term fixed-rate corporate bonds offering more than two percentage points (200 basis points) more in average coupon rate than floaters. Income-oriented investors should be aware of this discrepancy, especially given the outlook for short-term rates to stay near zero for at least another year.

Short-term, fixed-rate corporate bonds offer a large coupon advantage for now

The average coupon rate for the Bloomberg Barclays U.S. Floating-Rate Notes Index is 0.8%, while the average coupon rate for the Bloomberg Barclays U.S. Corporate 1-5 Year Bond Index is 3.1%.

Source: Bloomberg, using weekly data as of 4/2/2021. Bloomberg Barclays U.S. Floating-Rate Note Index (BFRNTRUU Index) and the Bloomberg Barclays U.S. Corporate 1-5 Year Bond Index (LDC5TRUU Index). Past performance is no guarantee of future results.

2. Floaters underperformed before and during the last rate hike cycle. The chart below is telling for those investors considering floaters today in anticipation of rate hikes down the road. In the two years leading up to the 2015 Fed rate hike, floaters underperformed by more than 2 percentage points.  Not only did floaters underperform in the 2 years leading up to the first rate hike, they continued to underperform in the 12 months following that rate hike.

Short-term, fixed-rate corporate bonds outperformed floaters in the two years leading up to the first rate hike and in the year after the hike

During the previous Fed rate-hike cycle, which began in December 2015, short-term fixed-rate corporate bonds outperformed floaters in the two years leading up to the first rate hike as well as the year after.

Source: Bloomberg. Total returns from 12/15/2013 through 12/15/2016. Indexes represented are the Bloomberg Barclays U.S. Corporate 1-5 Year Bond Index (LDC5TRUU Index) and the Bloomberg Barclays U.S. Floating-Rate Note Index (BFRNTRUU Index). Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.

Past performance is no guarantee of future results, of course, but it’s important to see how these two investments performed during the last rate hike cycle, given that both 2013 and today are characterized by a Fed funds rate range of 0% to 0.25%. Short-term fixed-rate corporate bond yields were a bit higher in 2013, however, as the index had an average yield-to-worst of 1.6% compared to just 1.0% today.

Investors may still want to consider floaters to limit the interest rate risk of their bond portfolio, but we suggest a more comprehensive approach to building a portfolio that also includes short-term fixed-rate corporate bonds as well.

What to do now

Floaters can be one way to reduce the average duration of your bond holdings, but they aren’t the “secret investment” that will limit price fluctuations while also providing outsized returns.

Floaters should certainly benefit if the Fed were to hike rates sooner rather than later, but that’s an unknown. Conversely, the longer the Fed keeps its policy rate near zero, the longer a floating-rate note investor would be missing out on the higher yields and higher income payments that short-term fixed-rate corporate bonds may provide.

It’s all about balance. An allocation to floaters allows investors to take advantage of an earlier-than-expected Fed rate hike cycle, but an outsized position could leave you earning paltry income payments should the Fed take a more patient approach to hike rates.

 

1As of 4/5/2021