Many are still expecting the U.S. Federal Reserve to move rates higher again before they end of the year, which is likely to put some upward pressure on bond yields across the spectrum. As we know, bond prices tend to move in the opposite direction of yields, so if yields are rising, bond prices are likely to be falling, creating headwinds for traditional fixed-income investments.
This is where floating-rate income funds may be able to help. A floating-rate income fund will invest in a portfolio of floating rate notes and leveraged loans. In very general terms, these are loans and notes issued by large corporations where the coupon payment is determined based on the prevailing rate of interest in the economy. Usually these loans are senior debt, and they can be secured or unsecured. Secured notes are typically collateralized by such things as accounts receivable, inventory, property, plant and equipment. They will typically have a maturity of between five and nine years.
Why floating rate notes?
There are a number of reasons to consider investing in floating rate notes. Because the coupon payment moves with the prevailing rate of interest, there is virtually no duration risk. For example, the duration on the FTSE/TMX Canada Universe Bond Index is approximately 7.6 years. This means that for every 1% rise in rates, your investment in the index is expected to fall by approximately 7.4%. In comparison, the duration of the Credit Suisse Leveraged Loan Index is listed at 0.3 years, making the duration risk almost negligible. This low duration occurs because the reference rate for the underlying loans is often reset every 30, 60, or 90 days, depending on the terms of the specific loan.
Higher yield
Another reason that these investments are attractive is their significantly higher yield. The FTSE/TMX Canada Universe Bond Index is yielding a little shy of 2% at the end of May, while the Credit Suisse Leveraged Loan Index is yielding north of 5%.
Combined, these two factors would be expected to provide for a better risk-adjusted return than traditional fixed income in a rising rate environment.
While these certainly appear to be attractive, there are some significant risks to consider. They include the following:
* Rate floors.Many floating-rate loans have what is referred to as a floor rate, which is a minimum coupon rate that will be paid, regardless of the prevailing reference interest rate. Because of these floors, many issues have been paying artificially high yields in the current low-rate environment. When rates do start moving higher, it may be a while before there is a noticeable bump in the yields offered by these funds, because rates must move beyond the minimums.
* Credit risk.This is perhaps the biggest risk, because the overwhelming majority of companies that issue these types of investments are not investment grade. If we see a sharp decline in the health of the overall economy, these notes could be hit hard as the risk of default increases. Yes, some are secured and backed by such things as assets or receivables, but that doesn’t mean you won’t lose money. Looking back at the period between May 2008 and December 2008 these funds dropped precipitously with the BMO Floating Rate Income Fund dropping by 46% while the Trimark Floating Rate Income Fund fell by 27%. Traditional fixed-income investments posted gains, with the FTSE/TMX Canada Universe Bond Index rising by nearly 4%.
* Liquidity risk.One concern that has been hanging over the bond markets has been the worry that markets won’t have sufficient liquidity, particularly when things begin to get rocky. The worry is that without liquidity, the price movements, both to the up and down side will be amplified. This is particularly worrisome in lower-quality and non-benchmark issues.
* Costs.Most floating-rate funds carry MERs that are higher than traditional fixed income funds. For example, the MER on the Renaissance Canadian Bond Fund is 1.56%, while the Renaissance Floating Rate Income Fund carries an annual MER tag of 1.82%. While the higher expected return may help offset the additional cost, it is something that should be considered, particularly if rates don’t move up quickly.
Bottom line
Floating rate funds can be a good way to help protect your portfolio against rising interest rates through a lower duration and a higher yield to maturity. In fact, many bond managers will often times use floaters in their funds to help protect their portfolios, meaning if you hold an actively-managed bond fund, there is a chance you may already have some exposure to floating-rate investments.
Still, if you want to add additional exposure, I would suggest you proceed with caution, given the higher total risk profile. They are best used as a portion of your fixed income allocation and not as a full replacement for traditional bonds. Used prudently, they can provide additional yield and some downside protection to your bond exposure.
Courtesy Fundata Canada Inc. © 2016. Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc. This article is not intended as personalized advice. Investments mentioned are not guaranteed and carry risk of loss.
