Since the FED interest rate hike in December of 2016, floating rate bonds have caught the attention of bond investors. Floating rate funds are being sold to income investors as a way to make money in bonds during a raising rate environment. The case for floating rates notes goes like this: the FED is hiking interest rates which means bond yields should be going up. This is bad for the prices of traditional bonds, but because the yields on floating rate bonds “adjust” to an index like “LIBOR*” or the Fed Funds Rate, the yields of floating rate bonds will increase quickly – providing investors with higher yield and limited downside. What could go wrong?
Focus on the Yield
As with most investments, the devil is in the details. The yield on the iShares Floating Rate Bond fund is 1.17% (as of 3/31/17) – fact sheet here. This fund tracks a passive index of investment grade floating rate bonds. Since very few investment grade companies want floating rate debt, this particular fund is not very diversified across sectors. Why do few investment grade companies issue floating rate bonds?
Think about it this way: companies like IBM and Pepsi do not need floating rate bonds. If they issue debt they would rather take a “certain” expense (fixed rate) over a “uncertain”(floating rate) expense any day of the week. Because they have great credit, they can choose to issue debt at low fixed rates for long periods of time. Companies with low credit ratings may not be able to issue fixed rate debt at all. If they did, the rates and interest payments may be too high to manage. What they can do is issue floating rate debt at a reasonable rate for the company to manage (for the time being), and investors will be compensated when yields increase as interest rates rise.
So if the yield on the investment grade bond floating rate index is 1.17%, and your floating rate fund has a yield of 4%, what are you buying? You are probably buying junk bonds. You have traded one risk (interest rate risk) for another (credit risk). I think this floating rate fund from John Hancock is a good illustration of my point. The yield (as of 6/30/17) of this particular fund is 4.32% (great!), but 97% of the bonds in the fund are rated “BB” or below – squarely in “junk” territory (not great!).
What’s My Point?
Be careful with floating rate bonds. They can be a good diversifier, but funds with high yields and “junk” rated holdings may not have the consequences you intended. IF the economy keeps growing and IF the Federal Reserve keeps hiking interest rates then floating rate bonds should do fine – for a while. Those are big “ifs”. The last two economic cycles (ending in 2000 and 2008 respectively) ended with the FED hiking rates too high. Recessions ensued. Can you guess how well junk bonds perform during recessions? Terribly. And that’s really my main point with floating rate bonds: the economic circumstances that make floating rate bonds attractive (interest rate hikes) have historically been IMMEDIATELY followed by the economic circumstances that can crush owners of these bonds (recessions). Buyer beware.
Charles Brown is a Portfolio Manager and Financial Advisor at M. Brown and Associates in Naperville, Illinois
*London InterBank Offered Rate
The above article is informational in nature only and is not a recommendation to buy or sell securities. All information is gathered from sources believed to be reliable, but neither Charles Brown nor Ausdal Financial Partners, Inc guarantees the accuracy of the information. All investments carry a degree of risk. Individuals should consult with their tax and investment professionals before making changes to their investment portfolios.