RANDY FREDERICK: Bonds and bond yields tend to move opposite each other, and in a rising rate environment that could be unsettling for bond investors. Collin Martin, a fixed income strategist at the Schwab Center for Financial Research, joins me for the February 14 Schwab Market Snapshot to discuss a very unique type of bond that actually takes a totally different path. Welcome back, Collin.
COLLIN MARTIN: Hi, Randy. Thanks for having me.
RANDY: So, Collin, given that the Fed is likely to raise rates at least once, maybe even twice this year, some investors may be worried about the impact on their bond portfolio. But lately, you’ve been talking about a very unique type of bond that actually may benefit from rising rates. So can you tell us a little bit about this bond and how it works?
COLLIN: Absolutely. Investment-grade floating-rate notes, or “floaters” as they’re commonly referred to, are a type of investment that can actually benefit when yields are rising. So floaters are just a type of corporate bonds. They have set maturity dates, they generally have investment-grade ratings, but the key differentiator is the coupon rate. Unlike most bonds that have fixed coupon rates, the coupons on floaters are based off of a short-term benchmark like the three-month London Interbank Offered Rate, or LIBOR. There’s usually an additional spread on top of that reference rate to compensate investors for the additional risk of holding a corporate bond, like the risk of default. Now, LIBOR, which, again, is what those coupons are based off of, is highly correlated to the Fed Funds Rate. So if the Fed continues to hike rates this year, which we expect they will, that means that the coupon payments on floaters should rise also.
RANDY: So if I understand you correctly, it sounds like you’re saying that floaters can be beneficial because they tend to have a very stable price. Why is that?
COLLIN: Yeah, the floating coupon rates allows their prices to be relatively stable. The coupons on most floaters resets quarterly. So as short-term interest rates are rising, those coupons are adjusting, meaning the price doesn’t necessarily need to adjust much. Let’s compare that to a fixed rate corporate bond. If yields rise and the coupon on a fixed rate corporate bond is now lower than the market interest rate it will usually fall to make it more attractive so investors are interested in buying something with a lower coupon relative to what’s available in the market today. And that’s usually not the case with floaters, so their prices tend to be very stable.
Now, keep in mind, they are corporate bonds so they do have additional risks. And they can be volatile during periods of market stress or market volatility. For example, in 2009, during the financial crisis, the prices on floaters fell sharply. Now, we don’t expect that today. Economic growth is still positive, earnings appear to be improving, and monetary policies are still relatively easy. So those are all supporting factors for corporations.
RANDY: So it sounds like floaters may be appropriate for some bond investors, but they may not be for everyone. So can you tell us a little bit more about what type of investor might benefit from them and what else they need to know if they’re interested?
COLLIN: If you’re worried about the effect of rising interest rates on your fixed income investments, you might want to consider floaters. If you’re considering reducing your fixed income allocation today or if you’re still on the sidelines waiting for a better entry point, we think floaters are a really good way to stay invested in the bond market and can actually benefit with higher coupon payments and relative price stability if rates do rise.
Now, if you are interested there are a few things to know. So floaters can be bought individually, but the floater market is much smaller than the fixed rate corporate bond market, so sometimes finding individual floaters can be a bit tough. There are exchange traded funds and mutual funds that focus on floaters, but it can be a bit difficult to screen for those, so talk to a Schwab fixed income specialist. They can help give you a bit—a few more details about floaters and they can help you find an appropriate investment that’s right for you.
RANDY: Thank you so much, Collin. That’s all the time we have for today. If you want to read more from Collin, you can do that in the Fixed Income section of Schwab.com. And remember, you can always follow me on Twitter @RandyAFrederick. We’ll be back again. Until next time, invest wisely. Own your tomorrow.