Are Floating Rate Bonds More Common Than Fixed Rate

With the Federal Reserve likely to begin raising its target short-term interest rate as soon as its March meeting, we believe investment-grade floating-rate notes are worth consideration today.

Every bit the federal funds rate rises or falls, floater coupon rates tend to follow, and their prices aren't overly sensitive to fluctuating interest rates.

At that place are pros and cons to investing in floaters, still, and performance relative to fixed-charge per unit corporate bonds can vary. While they are certainly worth consideration today, it's of import to sympathise their various nuances, and to pay attention to the outlook for Federal Reserve policy, as the pace and magnitude of rate hikes can play an of import role in floating-rate note performance.

The nuts of floaters

Investment-grade floating-rate notes, normally referred to every bit "floaters," are a type of corporate bond investment whose coupon rates are tied to a curt-term criterion rate. A measure of additional yield is ordinarily added to the reference rate to compensate investors for the risks of lending to a corporation, such as the potential that it will default and neglect to brand timely payments on its debt. Considering these are issued by investment-grade-rated corporations, the "spread" betwixt the reference rate and the floating-charge per unit notation yield tends to exist relatively low, ordinarily in the 25- to 100-basis-point range.^one

The underlying reference rates for floaters can vary these days. Historically, floaters were referenced to the three-calendar month London Interbank Offered Charge per unit (LIBOR) but that charge per unit is in the procedure of being retired. Many recent floater bug utilize the Secured Overnight Financing Rate (SOFR) as the reference rate.

Any manner you piece it, the underlying reference rates are brusk-term rates and tend to have a stiff human relationship with the federal funds charge per unit.

Floater coupon rates tend to follow the lead of the federal funds rate

Source: Bloomberg, using weekly data every bit of 1/21/2022.

Bloomberg U.South. Floating Charge per unit Annotation Index (BFRNTRUU Alphabetize) and U.S. Federal Funds Target Charge per unit Mid Point of Range (FDTRMID). Past performance is no guarantee of future results.

Floaters are bonny in a rise-interest-rate environment because their prices are not very sensitive to changing involvement rates. Their coupon rate adjusts to shifts in brusque-term interest rates, so their prices don't need to. That results in more than stable prices regardless of what Treasury yields are doing. However, floater prices tin can fluctuate due to credit concerns. If the economic outlook deteriorates, floater prices can fall if corporations' ability to service their debts declines.

Three things to consider with floaters

The prospect of rising short-term interest rates doesn't necessarily mean that floaters are the right investment for all investors. There are pros and cons to investing in floaters, and their performance compared to fixed-rated corporate bonds has been mixed during previous Fed charge per unit-hike cycles. Hither are three things to consider before adding investment-class floaters to your portfolio:

i. Floater yields are lower than fixed-charge per unit corporate bond yields

The bond market tends to exist forwards-looking. When market place participants wait the Fed to start hiking rates, many bail yields volition ascension in apprehension. For example, the 2-year Treasury yield rose above 1% in mid-Jan for the first time since before the pandemic began. Meanwhile, the 3-month Treasury nib yield was anchored at roughly 0.fifteen%. One- to five-year fixed-charge per unit corporate bail yields accept risen due to this dynamic with Treasury yields, while floater yields remain stubbornly low. Continue in heed that floater coupon yields should rise one time the Fed begins to hike rates, simply it will have a number of hikes before the average yield catches upwards to the yield-to-worst² of the fixed-rate index. If you're looking for higher income payments today—rather than waiting for the Fed to hike rates—curt-term corporate bonds might make more sense. Equally the chart below illustrates, information technology would have roughly five Fed rate hikes for the yield of the floater alphabetize to catch the yield of the Bloomberg U.S. Corporate 1-5 Year Bond Alphabetize.

Floater yields are well below short-term, stock-still-charge per unit corporate bail yields today

As of January 21, 2022, the yield of the Bloomberg U.S. Floating-Rate Notes Index was 0.4% while the yield of the Bloomberg U.S. Corporate 1-5 Year Bond index was 1.8%. Since 2012, the floating-rate index yield has usually been lower than the yield on the 1-5 year corporate bond index.

Source: Bloomberg, using weekly data as of 1/21/2022.

Bloomberg U.S. Floating Rate Note Index (BFRNTRUU Index) and Bloomberg U.Due south. Corporate 1-five Year Bond Alphabetize (LDC5TRUU Index). Yield-to-worst is the lower of the yield-to-call or yield-to-maturity. It's the everyman potential charge per unit of render for a bond, absent a default. Past operation is no guarantee of future results.

2. Floater prices tend to be very stable

This is a key benefit for investors, especially for those who are worried well-nigh the effect of rising interest rates on their bond holdings.

The prices and yields of fixed-charge per unit bonds have an inverse relationship. If a fixed-charge per unit bail'south yield rises, its price falls (and vice versa). If market involvement rates rise, a low fixed coupon rate may no longer be bonny—the price will generally autumn to make its yield more in line with market interest rates.

That'southward not the case with floaters. Because their coupons adjust with market interest rates, their prices don't need to. Over time, floater prices tend to be very stable, whether the Fed is raising or lowering interest rates. Keep in listen that floaters can help mitigate involvement rate chance, but they nonetheless accept credit risk, like the risk of default. If credit atmospheric condition deteriorate and the creditworthiness of corporate bond issuers declines, floater prices can autumn just like the prices of fixed-charge per unit bonds. Sector concentration is some other hazard. Bonds from the financial institutions sector make up 58% of the Bloomberg U.S. Floating-Rate Notes Index, significant it's difficult to go much sector diversification and the market could be sensitive to periods of fiscal stress.

The chart below illustrates these risks, equally floater prices roughshod during the 2008-2009 fiscal crisis, the 2011 European debt crisis, and in the early days of the 2020 pandemic.

Floater prices tend to be much more than stable than fixed-rate bond prices

Since 2003, the average price of the Bloomberg U.S. Floating-Rate Notes Index has tended to be more stable than the Bloomberg U.S. Corporate 1-5 Year Bond Index. However, floater prices fell sharply during the 2008-2009 financial crisis, during the 2011 European debt crisis, and in the early days of the 2020 pandemic.

Source: Bloomberg, using weekly data as of one/21/2022.

Bloomberg U.S. Floating Rate Note Index (BFRNTRUU Index) and Bloomberg U.S. Corporate 1-5 Year Bond Index (LDC5TRUU Index). Past performance is no guarantee of future results.

3. Performance varies

The step and number of charge per unit hikes tend to influence how floaters perform relative to short-term, fixed-charge per unit corporate bonds. During the 2004-2006 charge per unit-hike bike, floaters significantly outperformed equally the Fed hiked rates a total of 17 times, raising its target rate from 1% in June 2004 all the way to 5.25% by June 2006. Not just did floaters outperform their stock-still-rate counterparts, but they as well experienced a lot less volatility.

Floaters outperformed during the 2004-2006 rate hike wheel, with little volatility

From June 2004 to June 2006, floaters' total return climbed steadily, reaching 7.2% by June 2006. During the same time period, short-term, fixed-rate corporate bonds total return increased to 4.5%, with more volatility.

Source: Bloomberg. Total returns from 6/25/2004 through 6/thirty/2006.

Bloomberg U.S. Corporate i-v Twelvemonth Bond Index (LDC5TRUU Index) and Bloomberg U.S. Floating Rate Notes Index (BFRNTRUU Index). Total returns assume reinvestment of interest and majuscule gains. Indexes are unmanaged, do not incur fees or expenses, and cannot exist invested in direct. Past performance is no guarantee of future results.

Fast-frontward to 2015, and the performance numbers are non as impressive. Over the iii-year rate-hike cycle, floaters only modestly outperformed short-term, fixed-rate corporate bonds, only much of that outperformance came at the finish of the rate-hike cycle. For the first 2 years of the charge per unit-hike bike, floater functioning lagged as the Fed took a very patient arroyo to rate hikes. The Fed raised its target charge per unit by 25 basis points in December 2015, and then waited a total twelvemonth to hike rates again. When all was said and done, the Fed hiked rates a total of nine times over three full years, compared to 17 times over just two years in the previous bicycle.

Floaters eventually outperformed fixed-rated corporates during the last bicycle, also volition lilliputian volatility

From December 2015 to December 2018, the cumulative total return of the Bloomberg U.S. Floating-Rate Note Index rose to 5.9%. The cumulative total return of the Bloomberg U.S. Corporate 1-5 Year Bond Index rose to 5.6%, with more volatility.

Source: Bloomberg. Total returns from 12/xi/2015 through 12/21/2018.

Bloomberg U.S. Corporate ane-v Year Bond Index (LDC5TRUU Alphabetize) and Bloomberg U.S. Floating Rate Notes Index (BFRNTRUU Index). Full returns assume reinvestment of interest and upper-case letter gains. Indexes are unmanaged, practice non incur fees or expenses, and cannot exist invested in directly. Past functioning is no guarantee of future results.

As we approach the beginning of the next Fed charge per unit hike cycle, the pace and number of rate hikes will play a large office in the performance of floaters. If the Fed hikes too rapidly and the economic outlook deteriorates equally a result, it might not exist able to fifty-fifty get to a ii% federal funds rate. In that scenario, floaters could underperform, every bit their income payments might not rise plenty to make up the deviation that fixed-rate corporate bonds provide today.

However, if the Fed takes a more patient approach to rate hikes—enough to deadening aggrandizement but not plenty to derail the potent economic momentum—and then information technology may be able to successfully increase the federal funds rate above the ii% level (or potentially fifty-fifty higher), in which case floaters may outperform as their coupon payments continue to grow.

What to consider now

Investment-grade floaters tin make sense as the Fed begins to hike rates. While functioning has been mixed compared to fixed-charge per unit corporate bonds during previous rate hike cycles, their low interest charge per unit sensitivity may make them more bonny for investors worried well-nigh the gamble of rising rates on their bail holdings. Floaters can allow you to stay invested in the bail market, rewarding investors with higher income payments as the Fed hikes rates, rather than trying to fourth dimension the market and waiting for the "correct" fourth dimension to invest in bonds.

One way to go straight exposure is through an exchange-traded fund (ETF) that tracks a floater index. Unfortunately there isn't a specific Morningstar category for investment-grade floating rate notes, but at that place is a way to screen for funds using the ETF screener. First start with "Taxable Bond" as the Fund Category, and and then under Morningstar Category, select "Ultrashort bond." Finally, on the left side of the screen, select "Fund Name" and include "float" every bit a descriptor. Using those criteria should provide some ETFs that focus on investment-class floaters, but keep in heed that might not exist the comprehensive list.

^ane One ground point is equal to 1/100th of one percentage, or 0.01%, or 0.0001. Thus 50 basis points is equal to 0.v% and 100 basis points is equal to one%.

ⁱⁱ Yield-to-worst is the lower of the yield-to-call or yield-to-maturity. It'south the lowest potential rate of return for a bail, absent a default.

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