A rising interest rate makes fixed-income investors nervous. A way they can benefit from that rise is through floating-rate debt.
Here’s how it works. Let’s say a below-investment-grade corporation needs $500 million to fund payrolls or an acquisition. The firm hires an investment bank to make it happen. That bank tells prospective lenders how much the firm needs and what the money’s for. It also provides company financials for lenders’ due diligence reviews, explains Lisa Kasparian, institutional portfolio manager with Fidelity Investments in Boston, Mass.
The lenders either hold the debt or give investors access by selling it to mutual funds, or to institutional players like pensions.
The debt’s coupon is the base rate (typically three-month Libor) plus a spread, which varies. “The spread is fixed for the life of the loan. What fluctuates over time is the Libor rate,” Kasparian explains. “It resets every 90 days. If Libor today is 30 basis points and three months from now it rises to 50, the coupon rate goes from 4.3% to 4.5%.”
When Libor goes up, income rises; when it goes down, income falls. Kasparian says 10-year Treasuries rose last year from about 1.5% to 3%. Libor hasn’t seen the same jump, but when short-term rates pick up, she suggests it’ll likely follow suit. “It’s tied to the broader global economy and there are signs of improvement.”
Credit risk of government bonds would be pegged between 0 and 1.
Floating-rate debt has low duration risk, which is a bond’s price sensitivity to rate fluctuations. When fixed-rate bonds take a hit as rates rise, floating-rate debt outperforms (in a declining-rate environment, the opposite’s true). That means it can counter sluggish performance of conventional bonds. The asset class’ benchmark—the S&P/LSTA Leveraged Loan Index—is negatively correlated to Canadian equities, investment-grade bonds and short-term bonds. Correlation to Canadian corporate bonds is about 0.1.
And while returns aren’t as strong as high-yield, when rates rise, floating-rate generally outperforms investment grade. In 2013, “overall market returns were about 5.2% in U.S. dollar terms,” Kasparian notes.
More risk to meet goals
The 30-year bond bull market was kind to many retirees, but funding goals now requires more risk. “They either need to go to longer-dated bonds—taking on more duration risk—or to take on more credit exposure,” says Kasparian. “That’s where [floating rate] comes in.”
And though these bonds are not investment grade, credit risk isn’t always bad. “Many of these companies are household names, so this is not the junk bond market.” What’s more, floating-rate debt holders are first in line if the company sinks.
Moody’s places the default rate at 3.4% (high-yield is 5% and investment grade is 0.1%). When a default does happen, investors historically recoup about 80% because the debt’s collateralized, Kasparian explains.
Right now, clients should worry more about duration risk than corporate bankruptcies, says Kasparian, which makes floating-rate a good buy.
“We expect to see continued economic growth; most forecasts are that defaults will remain fairly benign over the next year or two.”
Dean DiSpalatro is a Toronto-based financial writer.