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Floating-Rate Corporate Bonds and Interest Rates

Are Floaters an Answer to Rate Hike Uncertainty?

The past few years have been difficult for bond investors. With interest rates still near historic lows and the Federal Reserve taking a cautious approach to rate hikes—particularly in the wake of this summer’s political and economic uncertainty in Europe—many bond investors are sitting on the sidelines yearning for the higher yields of yore.

Floating-rate corporate bonds, or “floaters,” can help investors position their portfolios for an eventual rate increase. Unlike traditional bonds, whose interest rates are fixed, floaters’ rates are based on a benchmark rate, such as the three-month LIBOR (London Interbank Offered Rate), plus a spread—which means if the benchmark rate goes up, so does the floater’s.

 

Chart 1: How floater rates are determined

In the event of a rate increase (or in anticipation of one), investment-grade corporate floaters tend to reap the benefits more quickly than traditional bonds. That’s because most floaters make coupon payments quarterly (rather than the more-typical twice a year), plus short-term benchmark rates tend to move higher in anticipation of Fed rate hikes.

And if interest rates remain low, floaters can offer higher yields than cash or short-term Treasuries. They also have fairly stable prices.

Of course, the prospect of added reward typically comes with added risk, and floaters are no different. A floater’s spread tends to indicate its risk level: In general, the higher the spread, the lower the credit rating and the greater the risk of default. Because of this credit risk, floaters may also experience periods of price volatility if economic conditions deteriorate.

The market for investment-grade corporate floaters is small compared with the fixed-rate corporate bond market, although some exchange-traded funds (ETFs) that focus solely on floaters do exist. If you’re interested in floaters, consider working with a specialist who can help you navigate the market.

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Important disclosures:

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Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

Past performance is no guarantee of future returns.

Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Lower-rated securities are subject to greater credit risk, default risk and liquidity risk.

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