With the recent jump in bond yields, many investors are now looking for ways to protect their portfolio. As the past few weeks have shown us, when rates move higher, traditional bonds, particularly the safe-haven government bonds, are hit the hardest, taking on the full brunt of the losses (bond prices move inversely to rates). There are a few ways to help protect against this.
One way is to invest in short-term bonds, which aren’t affected as much when rates move. Another option is to invest in bonds that offer higher yields, for example corporate or high yield bonds, because the higher coupon payments help protect them from rising rates.
One often overlooked option to help protect against rising rates are floating rate notes. In very simple terms, floating rate notes are 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, which 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.
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. Unlike other bonds, their prices won’t be negatively affected when interest rates rise. They also tend to be a good hedge against inflation.
Within the context of a portfolio, floating rate notes tend to have low or even negative correlation to the traditional asset classes. For example, the Trimark Floating Rate Income Fund has low positive correlation to the main equity indices, and is negatively correlated to the DEX Universe Bond Index. This correlation profile will help to reduce overall volatility when used as part of a well-diversified portfolio.
Of course, floating-rate notes are not without their risks. Many of the floating rate notes available are not rated as investment-grade debt by the major ratings agencies. As a result, they can carry a high risk of default. Because of this, you will want to make sure that the any floating-rate investment you consider is well diversified, and that the managers have a sound investment process in place.
While recent performance has been decent, floating-rate note funds were hit very hard during the credit crisis of 2008. 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%. While nothing on the horizon suggests a similar event to be occurring, these products are likely to be hit hard again if there are any issues with liquidity in the corporate bond markets.
Floating rate notes are a fairly small segment of the investment universe, and there are only a handful of ways to invest in the sector.
The bottom line
Floating rate notes can be a good way to help protect your portfolio against the impact of rising interest rates. They are not without risks, and should not be used as a core holding. Instead, use them the way you would use high yield in your portfolios, keeping their exposure to a reasonable level given the total risks.
Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc., a consulting firm specializing in providing research and due diligence on a variety of investment products. He is also the publisher of Dave Paterson's Top Funds Report and Mutual Fund and ETF Update offering regular commentary and in-depth analysis of Canada’s top investment funds. He uses a unique analytical approach to identify funds with strong, risk-adjusted returns, and regularly publishes his insights and analyses in Fund Library.
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