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Fed Rate-Hike Pause: Why Fixed-Rate Bonds May Make Sense Now

By Collin Martin
Key Points
  • We believe investors should consider fixed-rate bonds over those with floating coupon rates.

  • With the direction of future Federal Reserve rate hikes less certain than just a few months ago, it’s unlikely that floating coupon rates will reset higher in the near term.

  • Fixed-rate bonds allow investors to lock in higher yields today, and may also provide investors with price increases if yields should move lower.

Fixed-rated bonds are beginning to look more attractive than investments with floating coupon rates.

Floating-rate bonds have coupon rates that are tied to short-term benchmarks, often with a strong relationship to the federal funds rate, the overnight rate that the Federal Reserve uses to implement monetary policy changes. With the Fed likely on hold for the time being, it’s unlikely that floating-rate coupons will rise much further, if at all, from their current levels. Investors who own floating-rate investments should consider shifting to those with fixed rates to lock in potentially higher yields.

Floating-rate note basics

Investment-grade floating-rate notes, or “floaters” for short, are a type of corporate bond whose coupon rate is based on a short-term benchmark interest rate, plus a spread. For most floaters, the reference rate is the three-month London Interbank Offered Rate, or LIBOR (LIBOR is being retired in a few years, however, and floaters likely will migrate to a new reference rate).

The spread is additional compensation for the risks involved with corporate bond investments, like the risk that the issuer will default. For example, if an issuer runs into financial troubles, it may become incapable of paying interest or even repaying the principal amount.

Three-month LIBOR—the reference rate to which most floater coupon rates currently are tied—tends to be correlated with the federal funds rate. So when the Fed hikes rates, as it has nine times since December 2015, floater coupon rates tend to rise as well. That has been a key benefit for floater investors over the years, as the average coupon rate of the Bloomberg Barclays U.S. Floating-Rate Notes Index is at its highest level since October 2008.

But floaters tend to make the most sense when the Fed is raising rates—a trend that’s unlikely to continue much longer, if at all.

Floater coupon rates are at their highest level in more than a decade

The average coupon rate for the Bloomberg Barclays U.S. Floating-Rate Notes Index was 3.4% as of Feb. 27, 2019, the highest average coupon rate since October 2008.

Source: Bloomberg Index Services Limited and Bloomberg, using monthly data as of 2/27/2019. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no guarantee of future results.

Fed preaches patience

The Federal Open Market Committee at its January 2019 meeting indicated that it would be patient with adjustments to its benchmark interest rate going forward. That’s a change in tone from previous meetings, where it judged that a continuation of its gradual increases were likely necessary.

Although the Fed is preaching patience, the markets aren’t so optimistic. Based on federal funds futures—an indicator of where investors expect the Fed’s policy rate to be down the road—there’s a greater chance of a rate cut than a rate hike by the end of this year and into 2020.

This reinforces our view that long-term rates have likely peaked for this cycle. While 10-year Treasury yields could drift modestly higher from current levels, we think they’ll likely stay in the 2.5%-to-3% range for the near term.

If the Fed does remain on hold for the near term, floater coupon rates are unlikely to rise any time soon. And if the next move by the Fed is in fact a rate cut, we suggest investors should extend the average maturities of their fixed income holdings to lock in the modestly higher yields they offer. We prefer maturities in the seven- to 10-year area for corporate bonds.

Fixed rate vs. floating rate

How do floater coupon rates stack up against fixed-rate corporate bond coupon rates?

While floater coupon rates have risen, they’re still 40 basis points, or four-tenths of one percent, below the average coupon rate of fixed-rate corporate bonds with an average maturity of seven to 10 years.

Floater coupon rates still remain below most fixed-rate corporate bond coupon rates, but the gap has narrowed

The average coupon rate for the Bloomberg Barclays U.S. Floating-Rate Notes Index was 3.4% as of Feb. 27, 2019, while the average coupon rate for the Bloomberg Barclays U.S. Corporate 7-10 Year Bond Index was 3.8%.

Source: Bloomberg Index Services Limited, using monthly data as of 2/27/2019. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no guarantee of future results.

Locking in fixed rates with slightly longer-term bonds also takes away some of the uncertainty for investors. While floaters have worked well over the past few years, investors in floaters today are playing a waiting game, waiting for short-term interest rates to rise further. But it’s unknown when, or if, they’ll rise again, meaning investors may miss out on the higher income payments that fixed-rate bonds may offer.

If the next move by the Fed were to be a rate cut, the average coupon rate would likely drop accordingly. For most floaters, the coupon rates reset quarterly, so rate cuts don’t take long to affect the market. Meanwhile, fixed-rate bond investors would still earn the higher yields that they have locked in.

An additional benefit of fixed-rate bonds relative to floaters is the potential for prices to move higher if yields fall. For fixed-rate bonds, their prices and yields have an inverse relationship. In other words, when yields rise, prices fall, and vice versa.

But floaters generally don’t have that same relationship. Because their coupon rates adjust to reflect market interest rates, their prices don’t need to. While that helps keep their prices relatively stable—a benefit during periods of rising rates—floaters likely won’t reward investors with higher prices if in fact yields do move lower from here.

What to do now

Consider shifting floating-rate investments into fixed-rate investments. Based on the recent shift in the Fed’s tone, there’s likely little room for floating-coupon rates to rise from here. We suggest investors lock in the higher yields that fixed rate bonds provide today, offering them the benefit of higher income payments today, while also providing potential price upside if yields should move modestly lower.

What You Can Do Next

  • Consider shifting floating-rate bond investments into fixed-rate investments to lock in the higher yields they offer. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
  • Explore Schwab’s views on additional fixed income topics in Bond Insights.
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Important Disclosures:

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 or economic 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.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

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

The Bloomberg Barclays U.S. Corporate Bond Index covers the U.S. dollar (USD)-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P and Fitch ratings services. This index is part of the Bloomberg Barclays U.S. Aggregate Bond Index (Agg). The Bloomberg Barclays Corporate 7-10 Year Bond Index is a component of the broad corporate bond index.

The Bloomberg Barclays U.S. Floating-Rate Notes Index measures the performance of investment-grade floating-rate notes across corporate and government-related sectors.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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