Investment-grade floating-rate notes, or floaters, appear relatively attractive given our expectation that the gradual pace of Federal Reserve rate hikes will continue.
Floaters can reward investors with higher income payments, while also offering relative price stability.
They do come with risks, however, such as credit risk and sector concentration.
Worried about the impact of rising bond yields on your fixed income investments? You might want to consider investment-grade floating-rate notes.
Floating-rate notes are a type of bond whose coupon rate rises with short-term interest rates. That characteristic offers two key benefits for investors: higher coupon payments as interest rates rise, and relative price stability.
Investment-grade floating-rate notes, or “floaters,” are a type of corporate bond whose coupon rate is based on a short-term benchmark rate plus a spread. For most floaters, the reference rate for coupon payments is the three-month London Interbank Offered Rate (LIBOR).
The spread is additional compensation for the additional risks that corporate bonds offer, like the risk that the issuer will default, or become incapable of paying interest or even repaying principal. The size of the spread is an indication of the risk level—the wider the spread, the riskier the floater.
For example, a floater might have a coupon rate of “three-month LIBOR plus 1%.” Today, three-month LIBOR is roughly 2.3%, meaning the annual coupon rate offered on this floater would be 3.3%.
The reference rate that floaters base their coupon payments on is highly correlated to the federal funds target rate, a short-term rate that banks charge each other for overnight loans and a benchmark rate for Federal Reserve monetary policy. So when the Fed hikes the federal funds rate, floater coupon payments tend to rise as well. The average coupon rate of the Bloomberg Barclays U.S. Floating-Rate Notes Index is now 3%, its highest rate in nearly 10 years, and up more than two percentage points (2%) since the Fed began hiking rates back in December 2015.
Floater coupon rates tend to follow the trend of the federal funds rate
Source: Bloomberg and Barclays. Monthly data as of 9/14/2018. Bloomberg Barclays U.S. Floating-Rate Notes Index and Federal Funds Target Rate Mid Point of Range (FDTRMID). Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no guarantee of future results.
Floating coupon rates don’t just offer investors the benefit of growing income payments when short-term interest rates are rising—they also help keep floater prices relatively stable.
For fixed-rate bonds, prices and yields generally move in opposite directions. If yields rise, fixed-rate bond prices tend to fall, to make the bond more attractive relative to other bonds with higher yields. But because the coupon rates on floaters adjust when rates rise, their prices don’t need to. Even as yields are rising, floater prices tend to stay relatively stable, and can even rise.
Floater prices have held in a tight range for more than five years
Source: Bloomberg and Barclays. Monthly data as of 09/14/2018. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no guarantee of future results.
When evaluating the performance (or potential performance) of any type of investment, it’s not just the price return that matters, but the total return. For most fixed income investments, total return comprises the price return and the income return, which is driven by the coupon payments.
In general, 2018 has been a disappointing year for many bond investments, as yields have risen sharply and prices, which move inversely to yields, have fallen. But floaters have so far been mostly immune from the negative effects due to those two supporting factors: rising coupon payments and relatively stable prices.
When compared to a fixed-rate corporate bond index with a similar average maturity, the benefits of floaters in a rising rate environment become even clearer. The chart below compares the cumulative year-to-date total return of the Bloomberg Barclays U.S. Floating-Rate Notes Index with the Bloomberg Barclays U.S. Corporate 1-5 Year Bond Index. While fixed-rate corporate bonds with one- to five-year maturities have been able to post a modestly positive total return this year, their cumulative total return was negative for more than half the year and only inched up to positive territory in early August. Contrast that with floaters, whose cumulative total return has been consistently rising, with relatively little volatility.
Floater performance has been less volatile than fixed-rate performance
Source: Schwab Center for Financial Research and Bloomberg. Cumulative total returns of the Bloomberg Barclays U.S. Floating-Rate Note Index and the Bloomberg Barclays U.S. Corporate 1-5 Year Bond Index. Total returns from 12/29/2017 through 09/14/2018. Returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.
While floaters do offer plenty of benefits, they do come with risks, including:
- Sector concentration. Financial institutions are a large issuer of investment-grade floating-rate notes—today, they make up 58% of the Bloomberg Barclays U.S. Corporate Floating-Rate Notes Index. This makes it difficult for investors to get much sector diversification, and raises the risk of price declines during periods of financial stress.
- Credit risk. Since floaters are issued by corporations, they are still subject to credit risk, like the possibility that issuer may not be able to make timely interest and principal payments.
While floater prices tend to be stable in non-crisis or non-recessionary periods, they can suffer price declines during periods of market stress. For example, the Bloomberg Barclays U.S. Floating-Rate Notes Index suffered a loss of more than 6% in September 2008—during just one month—as the financial crisis was getting underway.
However, we think corporations are generally in good shape today, despite some long-term risks brewing, and we think strong corporate earnings could continue to support the market in the near-term.
How to invest
Investing in floaters isn't as straightforward as investing in other parts of the fixed income market, unfortunately.
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 $500 billion, compared to more than $5 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, you can chat with a Schwab Fixed Income Specialist, who can help guide you toward investments that may make sense for you.
One thing to keep in mind is that investment-grade floating-rate notes are not the same type of investment as bank loans. Bank loans are a type of corporate investment with floating coupon rates, but they carry sub-investment-grade ratings and are relatively illiquid. Bank loans should be considered aggressive investments, and should not be considered a substitute for investment-grade floaters.
What to do now
Consider investment-grade floating-rate notes if you’re worried about the risk of rising yields to your bond investments. Floaters can reward investors with higher coupon payments if the Fed continues to hike rates, as we expect it will, but likely without the potential price declines to which many fixed-rate bonds may fall victim.