RANDY FREDERICK: The Federal Reserve has increased interest rates five times since the end of 2015 and shows no signs of letting up. Collin Martin joins me for the December 19th Schwab Market Snapshot to talk about floating-rate bonds, why some might be worth taking a look at and some maybe not.
So, Collin, last week, the Fed hiked interest rates for the third time this year, and they’re forecasting three more interest rate hikes next year. Now, in the past, you’ve talked about the benefits of owning bonds with floating coupon rates. So can you give us an update on these investments, especially now that we are clearly in an environment of rising short-term rates?
COLLIN MARTIN: That’s right, Randy. We think many floating rate investments should continue to benefit as the Fed continues to raise interest rates. Now, one thing we want to focus on first is investment-grade floating rate notes, or floaters.
Investment-grade floaters are a type of corporate debt. They generally have investment grade ratings, but their coupon rates are based off of short-term reference rates. The coupon rates are generally calculated as a short-term reference rate, plus a spread, which can be thought of as additional compensation for the risks that corporate bonds have. Like the risk of default, for example. And the reference rates on floaters tend to be highly correlated to the fed funds rate. So as the Fed is raising rates, coupon rates tend to rise as well.
For example, the average coupon rate of the Bloomberg Barclays U.S. Floating Rate Notes Index is up about a half a percentage point this year. And the prices on floaters tend to be relatively stable, also. Now, for fixed coupon bonds, prices and yields tend to move in opposite directions.
But for floaters, since the coupon rate is adjusting with market interest rates, their prices really don’t need to adjust. Now, keep in mind, during periods of financial stress or an economic downturn, for example, they still can suffer price declines because they do have the credit risk that corporate bonds have.
RANDY: Well, now, that all makes sense, but, more recently, I think I’ve heard you talk about the fact that not all floating rate bonds are the same. And bank loans, in particular, have underperformed this year despite the fact that we’ve had a rise in short-term rates. So can you tell us why that is and what makes those specifically different?
COLLIN: Bank loan coupon rates really haven’t risen much this year because issuers have been able to refinance their loans and issue new ones with lower and lower spreads. But I think it’s important to give some background on bank loans first. They’re very different from investment-grade floaters.
Bank loans have sub-investment-grade ratings, or high-yield ratings, so they’re much riskier than investment-grade floaters. They also tend to be relatively illiquid. So during periods of market volatility, they may suffer greater price fluctuations. Now, like floaters, their coupon rates are also based on short-term reference rates plus a spread, but the spread tends to be a little larger due to those additional risks.
Now, one caveat with bank loans is that they can often be redeemed by the issuer with very little notice. So this year, for example, given improving economic growth and improving corporate profits, issuers have been able to refinance and retire their existing loans, issuing new loans with lower and lower spreads, low enough to effectively offset the rise in short-term interest rates. So even though these are considered floating-rate investments, bank loans generally haven’t rewarded investors with higher coupon payments this year.
So if you’re considering investment-grade floaters and bank loans, it’s important to understand they’re very different. Bank loans should be considered aggressive investments due to their low credit ratings and relatively illiquid nature. And we think the trend in coupon rates may continue.
If the Fed does continue to hike rates, we think investment-grade floaters may continue to reward investors with higher coupon payments. But in the bank loan market, if demand remains high and issuers are able to refinance with lower and lower spreads, their coupon payments may not rise as much even if the Fed does continue to hike.
RANDY: That’s great information, Collin. Thank you so much for sharing it with us.
You can read more from Collin, if you want to, in the Insights and Ideas section of Schwab.com. And don’t forget, you can always follow me on Twitter @RandyAFrederick. We’ll be back again. Until next time, invest wisely. Own your tomorrow.