Investments with floating coupon rates can make sense if short-term interest rates continue to rise. But some floating rate investments come with significantly more risk than others.
Investment grade corporate floaters may appeal to investors looking to benefit from rising short-term interest rates, as their prices tend to be stable and their coupons should move higher as short-term rates rise.
Bank loans are riskier. Their coupons will likely benefit with higher short-term rates, but there’s little potential for price appreciation and more downside risk than investment grade corporate floaters.
Investments with floating coupon rates generally grow more attractive when interest rates are rising. Unlike their fixed-rate counterparts, whose prices tend to drop when rates rise, floating-rate investments actually yield more income. But not all floating-rate investments are the same.
In this article we'll discuss investment grade floating-rate notes and bank loans—two types of investments that may seem similar at first glance, but actually have very different risk and return profiles. Before investing in either type of investment, it's important to understand how they work and the potential risks involved.
Investment grade floating-rate notes
Investment grade floating-rate notes, or "floaters," are a type of corporate bond whose coupon rate is based on a short-term benchmark interest rate—usually the three-month London Interbank Offered Rate (LIBOR)—plus a spread. For example, a coupon rate may be three-month LIBOR plus 1%, or 100 basis points. When the benchmark rate rises or falls, the floater's coupon rate moves with it.
The size of the spread is an indication of the risk level—the wider the spread, the riskier the floater—so investors should think of it as compensation for taking on increased risk.
We see two key benefits to investment grade floaters today:
- Potential for income payments to rise as short-term interest rates rise
- Relatively stable prices, even if interest rates are rising
The three-month LIBOR is highly correlated to the federal funds rate. We expect the Fed to hike rates two or three times this year, so the coupon payments on corporate floaters should rise accordingly. And most investment grade floaters make quarterly, rather than semiannual, interest payments, which means investors can reap the benefits of higher rates fairly quickly.
The three-month LIBOR has risen by 70 basis points since July 2015 and is now at its highest level since April 2009. Floater coupons have changed in turn—the average coupon rate of the Bloomberg Barclays U.S. Floating-Rate Notes Index is up to 1.6%, its highest level in nearly eight years.
Floating coupons have benefited quickly after Fed rate hikes
Source: Bloomberg and Barclays. Monthly data as of 12/31/2016. Bloomberg Barclays U.S. Floating-Rate Notes Index, U.S. Federal Funds Target Rate Mid Point of Range (FDTRMID) and BBA LIBOR USD 3-Month (US0003M). Past performance is no guarantee of future results.
Floater prices tend to be stable, as well. This is a function of their variable coupon rates, which give floaters lower durations. Duration is a measure of how quickly an investment delivers its returns to investors and therefore serves as a gauge of interest rate sensitivity. Basically, the more returns you collect today, the less risk you face from future interest rate increases.
Calculating duration can be complex, but the rule of thumb is that for every percentage-point rise in interest rates, a bond's price will fall by 1% for every year of duration. So, if a bond had duration of 10, and rates rose by one percentage point, the bond's price would be expected to fall 10%.
Investment grade floaters tend to have durations that are near zero thanks to their variable coupon payments. The average duration of the Bloomberg Barclays U.S. Floating-Rate Notes Index is just 0.13, much lower than fixed rate indexes with similar average maturities.
Despite their low durations, corporate floaters do come with risks, however. A big one is the possibility the corporation may not be able to pay the loan, resulting in a default. In addition, financial institutions account for more than half of the issuance in the floater market. This makes it difficult for investors to get much sector diversification and raises the risk of price declines during periods of financial stress.
While floater prices tend to be stable during non-crisis periods, the chart below shows how prices dipped during the 2008 financial crisis and again in 2011 at the peak of the European debt crisis. But floater prices are significantly less volatile than bank loans, which we'll discuss below.
Floater prices have tended to be less volatile than bank loan prices
Note: While the market value of a floating rate note is relatively insensitive to changes in interest rates, the income received is highly dependent upon the level of the reference rate over the life of the investment. Total return may be less than anticipated if future interest rate expectations are not met. Past performance is no guarantee of future results. Source: Bloomberg. Weekly data as of 12/31/2016.
Bank loans, also called senior loans or leveraged loans, are a type of corporate debt that also have floating coupon rates, but they are otherwise different from traditional bonds and even investment grade floaters.
They are private investments that are generally held by funds or large institutional investors, and carry sub-investment grade, or junk, ratings. As a result, bank loans should always be considered aggressive investments.
Bank loans tend to be senior to an issuer's traditional corporate bonds, and they are secured, or collateralized, by a pledge of the issuer's assets. Secured doesn't mean safe, however: Bank loans still carry sub-investment-grade ratings, and can default. They also tend to be illiquid. Rather than trading electronically on the over-the-counter market like most corporate bonds, bank loans often need to be physically delivered (by faxing the paperwork, for example) to the buyer. This makes them harder to sell, and can lead to price declines during periods of market volatility.
Like investment grade floaters, the coupon rates on bank loans tend to be based on the three-month LIBOR plus a spread, but the spreads on bank loans are usually much wider than those for investment grade floaters to compensate for the additional risk. Many bank loans have what's known as a "LIBOR floor," which means that regardless of how low three-month LIBOR is, the coupon rate will be based on the higher of the floor or the actual level of LIBOR. Most bank loans have floors of 1% or below, so with three-month LIBOR currently at 1%, the floors aren’t much of an issue today.
How do they compare?
The chart below shows how investment grade floaters and bank loans have performed in terms of returns and risks. While bank loans have offered higher annualized returns, they also come with significantly more volatility, measured by the annualized standard deviation.
Bank loans have generated higher annualized total returns than investment grade floaters, but with nearly four times the volatility
Source: Schwab Center for Financial Research with data provided Bloomberg and Barclays. Bloomberg Barclays U.S. Floating-Rate Notes Index and the S&P LSTA U.S. Leveraged Loan 100 Total Return Index. The 10-year calculations use monthly data from 1/2007 through 12/2016. Returns assume reinvestment of bond principal and interest and are not adjusted for taxes. Indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.
Given current prices, there isn't much room for bank loan prices to rise today. As the price chart above illustrates, the average price of the S&P/LSTA Leveraged Loan 100 Index is $98.8, not far off from its post-crisis peak of $99.1, reached in July 2014. Bank loan prices rarely rise above their par value of $1,000 because the issuer is usually allowed to refinance them with little notice. (While loans and bonds are issued in $1,000 denominations, bond index prices are generally represented on a $100 scale.) In other words, if the price rises above par, the issuer can likely refinance at a lower interest rate. Keep this in mind when setting expectations. In 2016, the total return of the bank loan index was 10.9%, buoyed by the rise in price.
This year, however, coupon payments will likely drive the total return since there's not much room for prices to rise.
How to invest
Investing in floaters or bank loans isn't as straightforward as investing in other parts of the fixed income market.
For investment grade corporate floaters, investing in individual bonds is an option, but the market is significantly smaller than the fixed-rate corporate bond market. The amount outstanding of the Bloomberg Barclays U.S. Floating-Rate Notes Index is a little more than $300 billion, compared to roughly $4.6 trillion for the Bloomberg Barclays U.S. Corporate Bond Index. Given that there are fewer options with corporate floaters, investing in individual bonds could be a challenge. For those looking for more diversification or the benefit of a professional manager, a mutual fund or exchange-traded fund (ETF) may make more sense. Unfortunately, there is no explicit category for investment grade floating-rate bonds, according to Morningstar. Rather, they fall under the "Ultrashort Bond" category, which includes other types of short-term fixed income investments, as well. If you’re looking for mutual funds or ETFs that focus on investment grade floaters, chat with a Schwab Fixed Income Specialist, and they can help guide you towards investments that may make sense.
Investing in bank loan funds is a bit more straightforward—Morningstar actually has a designated category, making it easier to find them. If you’re interested in bank loans, check out the Mutual Fund OneSource Select List or Schwab ETF OneSource and look for those options that fall under the "Bank Loan" Morningstar category.
What to do now
If you’re building a fixed income portfolio, how do these types of investments fit in?
Investment grade floating-rate notes may make sense for investors looking for more conservative or moderate investments that offer slightly higher yields than other short-term alternatives, like Treasury bills or short-term Treasury notes, but they do come with some additional risks. And if short-term interest rates rise, as we expect, investment grade floaters may offer more price stability than investments with fixed coupons.
Bank loans do offer higher yields, but also come with significantly more risks. They should be considered part of the aggressive portion of your fixed income holdings given their potential for more price volatility. We would suggest investors avoid chasing yield with such investments. They should be considered a complement to your core portfolio holdings, not a substitute.
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