COLLIN MARTIN: Investors are often worried about the risk that rising yields pose to their fixed income investments. After all, bond prices and yields tend to move in opposite directions, so when rates are rising that tends to push prices lower. But that relationship doesn’t necessarily ring true for investments with floating coupon rates. I’m Collin Martin, and this is Bond Market Today.
There are a lot of different types of investments that have floating coupon rates, but we’re going to focus on the investment grade corporate floating rate note market, or floaters, for short. Floaters are just a type of traditional corporate bond, like other corporates that have set maturity dates, set par values, they’re issued by corporations, and they generally have investment-grade credit ratings. But where they differ from traditional bonds is their coupon payments. Their coupons payments are based off of short-term reference rates plus a spread. The spread can be considered compensation for the risk of investing in a corporate bond, like the risk of default. And another key characteristic of floaters is that they generally make coupon payments quarterly, or four times a year, compared to traditional corporate bonds that make semiannual bond coupon payments. That can help with the planning process for investors who are looking for more consistent income payments.
Now, we see two key benefits with investment-grade floaters as we expect interest rates to rise. The first is higher coupon payments. The reference rate that floater coupons are based off of have a strong relationship with the Fed Funds Rate. So as the Fed continues to gradually boost rates, as we expect, investors should be rewarded with higher coupon payments. The second is relatively stable prices. Unlike fixed rate bonds, with floaters, since their coupon payments adjust with higher yields, their prices don’t necessary need to. So even during period of rising yields, the average prices of floaters tend to be relatively stable.
Now, floaters do come with risks, of course. Since they are issued by corporations, their prices might not be as stable during periods of financial distress or an economic downturn, or some sort of financial crisis. Now, another risk is sector diversification. Financial institutions are a heavy issuer in the investment-grade floating rate note market. So if you’re investing in floaters you’re likely to have a high concentration in financial issues.
So with our expectation that the Fed is going to… likely to continue boosting its benchmark interest rate, we think floaters today can be a great way for investors to stay invested in the market and actually be rewarded with higher income payments.
If you’re interested in learning more about bonds, or fixed income, in general, you can go to Schwab.com, click on the Insights and Ideas tab, and then click Fixed Income, or you can go to YouTube and subscribe to the Charles Schwab YouTube Channel. Thanks for watching.