Floaters

The stock market finally performed well last week. This is great to see after such poor performance this year. Investors favored what had been most beaten down while selling energy stocks, the only sector that had been positive lately. It’s common to see stock prices tail off a bit after a strong short-term run and markets are gyrating this morning, so don’t be shocked if this week isn’t a repeat of last (but I’ll take it, don’t get me wrong…).

So-called core bonds can usually be expected to pick up some of the slack when stocks are down, but not this year. So far in 2022 bonds have been down with stocks, falling about 5% with variation around that depending on the bond index. Stocks had been down 12% going into last week but the 6% move has halved that, dimming the light further on bonds.

Stocks and bonds march to different tunes, or at least sometimes different steps to the same tune. Before Russia’s invasion of Ukraine investors had been focusing their concern on interest rates and inflation. The outlook has obviously gotten more complicated since. The situation in Europe seems to be settling in for a longer-duration conflict, underlining the question mark investors have for the weeks (or months?) ahead. And the Fed has started raising short-term interest rates, bumping the benchmark rate by 0.25% last week. The Fed seems set to keep raising like this a handful or more times this year. Had Russia not invaded Ukraine the Fed may have started moving rates up faster. And they’ve indicated not wanting to tighten economic conditions too quickly amid high levels of global uncertainty, even though there’s lots of uncertainty here at home due to inflation. How’s that for a tough job!

While anxiety around all this feeds into the stock market, it absolutely continues to permeate the bond market and is why bonds haven’t performed as well as they’d be expected to when stocks were down. So let’s finish up our discussion from several weeks ago of typical bond alternatives.

To clearly state my bias, I’m not suggesting you dump your bonds and go on a bond alternative buying binge. I like high-quality fixed-rate bonds and have used them in client portfolios for many years. And I don’t see this changing dramatically, even though we’re still going through an interest rate-driven adjustment phase with the bond market.

That said, there’s room to add additional safety through diversification for some portfolios, just as there’s room to raise risk a bit to increase investment income in other portfolios. That’s why we’ve looked at annuities, preferreds, convertibles, even REITs, as alternatives for some of your core bonds. Now let’s round out our list by looking at “floaters”.

Floating Rate Bonds –

Floaters, as they’re often called, are shorter-term bonds issued mostly by corporations but also by governments, even ours. A key point is the interest rate paid to investors is variable, based on a fixed spread over an index such as LIBOR or one of the Fed or Treasury indexes. Floaters are said to be good in a rising-rate environment because, unlike typical bonds that pay fixed interest for the entire term, payments from floaters rise as their benchmark rate rises. The increase is often capped, however, so if rates took off chasing runaway inflation, for example, floaters wouldn’t entirely keep up.

So far this seems like a near-perfect combination for our current rate environment, right? Maybe, but with a few key caveats.

First, floaters with more attractive terms are often issued by companies with higher credit risk than fixed-rate borrowers. This means the benefit of rising interest payments as rates rise can, and sometimes quickly, be counteracted by increased investor concern over creditworthiness. As an extreme example, the main floater index lost almost 29% during 2008 compared to core bonds rising about 5%.

Second, according to Vanguard, floaters have tended to outperform core bonds while interest rates are rising but then underperform in the year(s) following a rising cycle. This can happen due to the first issue (credit worthiness and spooked investors) or, ironically, changes in interest rate expectations. Both factors conspired to thwack floaters during the early days of the pandemic. To be fair, core bonds also fell, but by maybe half as much as floaters.

And third, floaters pay low interest rates compared to core bonds until rates rise, then often step up gradually. The iShares Floating Rate Bond Fund, ticker symbol FLOT (a good option in this space, by the way), paid a 12-month yield of 0.41%, compared with about 2% for core bonds. Maybe floaters close that gap this year, but who knows? Also, one could certainly argue that they lost less than core bonds during the same period, but hindsight is 20/20, as they say.

Essentially, investing successfully in floaters requires timing the right entry and exist points over a relatively short period, maybe a couple of years or less. The speculative nature of that kind of runs counter to the reasons for owning bonds in the first place, but maybe floaters are better thought of as add-ins, or satellites, for diversification within a core bond portfolio. If so, maybe they occupy a fifth, or perhaps a third, of your bonds if you want to be more active as rates rise.

Have questions? Ask me. I can help.

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