Should I add Floaters to my Portfolio?

Rick Welch |

At its March meeting the Federal Reserve, as widely expected, raised its benchmark interest rate by 0.25% (25 bps), the first rate hike since the end of 2018. With this initial hike, the Fed also signaled an aggressive path forward with rate hikes coming at each of the remaining FOMC meetings in 2022. Most analysts predict a larger 50 bps hike at both the May 3-4 and June 14-15 meetings. The last time the Fed made more than one large hike (50 bps or more) in a calendar year was 1994, long remembered as the year of the “bond massacre.” For fixed income investors, the expectation of higher rates brings with it the need for a tighter focus on how their fixed income portfolio allocation is constructed. Of primary concern is increased interest rate risk, which is the risk of falling bond prices due to a rise in market interest rates (remember price and yield are inversely related). In periods of rising rates, many investors look to alternative fixed income assets like floating rate securities (or floaters) which offer protection against rising interest rates and can reduce the rate sensitivity of their bond portfolio. Floaters have very low effective duration (which measures the sensitivity of a bond’s price to changes in interest rates) that is typically close to their reset frequency. Adding floaters can also provide additional bond portfolio diversification as they have low correlation with corporate bonds (0.35) and negative correlation with government bonds (-0.45).

Floaters are defined “as securities whose stated interest rate floats or adjusts (resets) periodically based on a predetermined benchmark. Once the benchmark is selected, the issuer will establish an additional spread that it is willing to pay in excess of the benchmark rate.”  Most floaters use a three-month rate which means they pay interest and have the coupon rate reset on a quarterly basis. Many floaters are issued with either a cap (maximum interest rate the issuer will pay regardless of benchmark rate movement), a floor (minimum) or both.   The key difference between floaters and fixed-rate bonds is how each investment type reacts to movements in market rates. A floating rate security tends to maintain its value, with less price fluctuation, if rates rise whereas a fixed-rate bond of similar maturity will lose value.

Floating rate securities come in several different forms. For ease of explanation we will divide the floater universe into two parts: investment grade floaters and bank loans.  A portfolio of investment grade floaters would provide exposure to corporate bonds, agency and non-agency mortgage securities, adjustable-rate mortgages and Treasuries. Investment grade floaters offer two key benefits, which are rate coupons that adjust upward as short-term interest rates rise and relative price stability.  The trade off here is that floaters typically pay lower interest rates than fixed-rate bonds do. On the opposite end of the risk spectrum is bank loans, which have become increasingly popular over the past several years. Bank loans are similar to high yield bonds in that both security types offer investors higher yields in exchange for taking on greater credit risk.  The majority of securities held by bank loan funds are rated BB (speculative grade) or lower. Most bank loans are senior secured notes which means they sit higher in a company’s capital structure than unsecured high yield debt and have historically had higher recovery outcomes in default or restructuring events. Like high yield debt, bank loans are not suitable for all investors. We view bank loans not as a core fixed income holding, but rather as a hedge against monetary tightening that can reduce interest rate sensitivity and improve diversification within a portfolio of investment grade fixed-rate bonds.