Your Investments: Is now the time for floating-rate bonds?

The next few years could provide a rude awakening to bond investors if interest rates start rising.

By AARON KATSMAN
November 3, 2010 22:12
4 minute read.
Aaron Katsman

Aaron Katsman 58. (photo credit: Courtesy)

As the wild ride in financial markets continues, investors are looking for ways to stabilize their portfolios.

One way of accomplishing this is through the use of bonds. The only problem is that with bond rates at historic low levels, the next few years could provide a rude awakening to some bond investors if interest rates were to start rising.

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What are bonds?
A bond is essentially a loan or an IOU issued by a corporation, government or government agency. When a person buys a bond, he is basically loaning money to the issuer in return for interest payments and the return of principal.

How does it work?
For example, let’s say Microsoft issues a bond that matures in four years at a fixed interest rate of 5 percent. If a person invests $10,000, he will receive $500 annually. Additionally, Microsoft repays the original $10,000 to the investor after four years. If Microsoft is unable to meet its obligations, the bond would default and the bondholder might lose some or all of his money.

Bonds are liquid investments, meaning they can be sold anytime. Keep in mind that if you sell before the maturity date, there is no guarantee of principal and the bond will be sold at the market price, which may be higher or lower than the purchase price.

Bond prices
Two main issues affect the prices of a bond. Bonds move in response to changes in the credit quality and financial stability of the issuer, as well as shifts in interest rates. Let’s focus on what happens if historically low interest rates begin to rise.

When interest rates climb, bond prices usually fall. The reason for this can be explained using the example of the 5% Microsoft bond. If interest rates fall, the 5% received on this bond becomes more attractive, and as the demand for the bond increases, so does the price. Conversely, if interest rates move up, suddenly the 5% isn’t as attractive as it was when rates were lower, so the price of the bond drops.

A new rate environment
While pundits have been calling for higher interest rates for some time, logic would indicate that at some point in the next year or two rates will almost certainly have to rise to fight off inflation caused by the US government’s 24/7 printing of money. If you are a bondholder, this can have huge ramifications. If you own individual bonds, as long as you hold them to maturity you will be okay, but if you need to sell prematurely, you could suffer a loss of principal.

Most investors don’t hold individual bonds and instead own bond mutual funds. According to MarketWatch: “While deflation may be an immediate threat, in the coming years the US is likely to see rising inflation and interest rates.

If that does happen, investors who’ve been fleeing to bond funds recently may see losses. Floating-rate funds won’t face that problem. That’s because their rates reset, between every 30 and 90 days depending on the security, usually in line with the London Interbank Offering Rate, or LIBOR. This means their rates will climb along with the market.”

Floaters
While many well-known corporations such as General Electric and Goldman Sachs are big issuers of floating-rate bonds, investors need to do some homework if they plan on investing via mutual funds. Many floating-rate funds invest in senior bank loans.

According to The Wall Street Journal: “Floating-rate funds mostly invest in bank loans made to, or bonds issued by, companies with low credit quality, and these portfolios usually sport average credit ratings well below the definition of ‘junk.’ A review of the funds that investment researcher Morningstar Inc. includes in its bank-loan category, and for which it has credit-quality data, shows none rated over double-B – near the top of the junk-rating spectrum but junk nonetheless. The credit risk is a red flag for conservative investors who may find floating-rate funds appealing as a way to stay in bonds even as interest rates rise.”

Floating-rate bond-fund managers argue that these funds’ holdings are superior to junk bonds because bank loans are higher up the credit structure and investors have a bit more protection.

Now more than ever floating-rate bonds may be a very useful tool in a bond portfolio.

But make sure you understand what it is that you are buying, so that you don’t end up with something much more aggressive than you want.

aaron@lighthousecapital.co.il
Aaron Katsman is a licensed financial adviser in Israel and the United States who helps people open investment accounts in the US.


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