Interest rates have been on the march since mid-October, thanks largely to the possibility of a hike in interest rates by the Federal Reserve. In general, bonds are vulnerable to falling market prices as a result of higher rates, but there are income investments that can be used to take advantage of, rather than fall victim to, rising rates. They’re known as floating rate instruments.
What’s happening with interest rates?
The 10-year US Treasury yield rose 0.30% from Oct. 14 through Nov. 16, based largely on anticipation of the Federal Reserve’s next move.1 Ever since the Fed drove the federal funds interest rate to near zero, the looming question has been, “Will next year finally be the year that the Fed raises rates?” In 2015, that question changed slightly but crucially to, “Will this year finally be the year that the Fed raises rates?” With possible liftoff this December, markets are more responsive (i.e., volatile) to every economic release—and investors are carefully parsing every statement from Fed Chair Janet Yellen.
Enter floating rate instruments
When rates rise, bond prices fall. The math behind this basic bond equation is premised upon a security’s fixed coupon payment. However, with a floating rate instrument, coupons are not fixed — they rise and fall based on an underlying benchmark, typically resetting every three months based on 90-day Libor. As a result, two things happen.
- Income and cash flow can rise as interest rates are rising (and fall if rates are declining). This can help preserve investor purchasing power if higher rates are accompanying rising inflation expectations.
- Prices for floating rate instruments tend to be more stable. Since cash flows are only “locked” until the coupon’s next reset date, price volatility as a result of interest rate changes can be a fraction of what is experienced with fixed rate investments.
Two floating rate ideas for today’s market
- Senior loans –Senior loans, also known as bank loans, are generally structured with floating rate coupons based on a spread over 90-day Libor. As such, interest rate risk tends to be measured by the number of days until the next rate reset, rather than the more traditional measure of duration used for fixed rate investments. Investors who are looking for exposure to high yield bonds, but are concerned about rates might prefer senior loans — most senior loans are to issuers rated below investment grade, yet these instruments have very low interest rate exposure.
|Yield to Maturity||Duration||Days to Reset|
|BofA Merrill Lynch US High Yield Index||8.15%||4.15||NA|
|S&P/LSTA Leveraged Loan 100 Index||7.13%||1.08||0-90|
|Sources: Merrill Lynch, Bloomberg, S&P/LSTA. As of Nov. 16, 2015. An investment cannot be made directly into an index. Past performance is no guarantee of future results.|
- Floating rate or “fixed to float” preferred securities –Investors have flocked to preferred securities in pursuit of higher income, but may not be aware of the significant rate risk imbedded in fixed rate preferreds. But not all preferreds are built alike. Floating rate preferred securities (or “floaters”) have coupons that reset periodically, typically based on a spread over 90-day Libor. “Fixed to float” preferred securities carry a fixed coupon for a set period of time (typically between five and 10 years), then convert to a variable rate structure. Interest rate risk is measured based on the amount of time until the next rate reset. As such, floaters have very low rate exposure. Meanwhile, fixed-to-float preferreds should experience measurable but diminishing volatility as a result of rate fluctuations during the fixed rate period of their life cycles. Both floaters and fixed-to-floating-rate structures tend to offer lower rate risk than fixed preferreds:
|Strip Yield||Effective Duration|
|BofA Merrill Lynch Core Plus Fixed Rate Preferred Securities Index||6.29%||3.87|
|BofA Merrill Lynch Adjustable Rate Preferred Securities Index||4.75%||0.13|
|Wells Fargo Hybrid and Preferred Securities Floating and Variable Rate Index||5.96%||3.00|
|Sources: BofA Merrill, Wells Fargo. As of Nov. 16, 2015. An investment cannot be made directly into an index. Past performance is no guarantee of future results.|
The rate path remains far from clear, but recent upward pressure on yields may have investors looking to decrease their interest rate exposure. Floating rate structures offer investors the opportunity to participate in, rather than fall victim to, a rising rate environment.
Investors can access the senior loan market through the PowerShares Senior Loan Portfolio (ticker: BKLN).
Investors can access the floating and fixed to floating rate preferred market through the PowerShares Variable Rate Preferred Portfolio (ticker: VRP).
1 Source: Bloomberg as of Nov. 23, 2015