Using floating rate bonds to increase income

We have heard for the last six or seven years that interest rates in the US were going to head higher. I guess at some point all prognosticators get it right, as indeed, the Federal Reserve has slowly been raising interest rates. More important than what’s happened over the last few months, is that the Federal Reserve has stated that it plans to continue raising rates throughout 2018, and there is a good chance into 2019 as well. The main reason for the rate hikes is due to the stronger economy. With strong growth, impressive job creation, a friendlier regulatory environment and tax cuts, it appears that the President Trump economic agenda is working. Now that there is a strong economy, the danger is that if interest rates stay at or near zero percent, the economy will overheat and inflation will rear its ugly head. The Fed wants to cut off any inflation and as such has been raising rates.

It wasn’t long ago that my clients were getting 0.1% on their money-market accounts and now money market is paying nearly 1.3%. Not Earth-shattering, but we see from the market that this number is heading even higher. For those who currently own fixed-income investments, most notably bonds, they are watching as the principal value of their “safe” investments continues to drop. Since the beginning of the year, long-term US Treasury bonds as measured by the Vanguard Long-Term Bond ETF have dropped by nearly 6%! Not good for a conservative investment.

• Technical aspect

A bond is essentially a loan issued by a corporation, government or government agency. When a person buys a bond, the buyer is basically loaning money to the issuer in return for interest payments and the return of principal.

For example, let’s say Apple issues a bond that matures in four years at a fixed interest rate of 2.5%. If a person invests $10,000, the buyer will receive $250 annually and in four years Apple pays back the $10,000 to the investor. If Apple would be unable to meet its obligations, the bond would default, and the bondholder may lose some or all of their money. Bonds can be sold at any time, but 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

How do bond prices move? This is something that most investors don’t know. In fact, BlackRock did a survey last year and only 31% of respondents understood the following: When interest rates climb, bond prices usually fall.

Why? Let’s use the example of the 2.5% Apple bond given above. If interest rates fall, the 2.5% 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 2.5% isn’t as attractive as it was when rates were lower, so the price of the bond drops.

• What to do?

As I mentioned, US long-term Treasury bonds have fallen 6% and investors don’t know what they should do to protect their principal. After all, bonds, according to conventional wisdom, are very safe investments and “can’t” lose money. Well, I guess once again conventional wisdom is wrong. Bonds can be volatile and can drop in value.

If you own individual bonds, as long as you hold them to maturity you will be okay. But in today’s investing culture, many investors don’t own individual bonds; rather they invest in exchange traded funds (ETFs) that track bonds, or in bond mutual funds, and they are losing money quickly.

• Floating rate bonds

Mike Hyman, CIO Global Investment Grade and Emerging Markets at Invesco writes, “What differentiates them from fixed coupon bonds is that their interest rates reset every one to three months, depending on a reference rate (historically LIBOR) and an additional percentage amount, a “spread,” that reflects the credit and liquidity risk of the issuer and asset class. As short-term rates increase, the coupon on the floating rate asset increases. The result is an asset with potentially reduced exposure to interest rate sensitivity. As a result, floating rate bonds may be an option for fixed income investors concerned about rising interest rates.”

• Risks

Many floating rate funds invest in senior bank loans. These are bank loans made to companies which often may not have the best credit ratings.

Proponents counter that these funds’ holdings are superior to junk bonds because bank loans are higher up the credit structure, and as such, investors have a bit more protection.

With regular bonds potentially set to continue their drop over the next 12-18 months, floating rate bonds may be a very useful tool in a bond portfolio, but as with all investments, make sure you understand what it is that you are buying, so that you don’t end up with something different than you anticipated.

The information contained in this article reflects the opinion of the author and not necessarily the opinion of Portfolio Resources Group, Inc. or its affiliates.

The writer is author of ‘Retirement GPS: How to Navigate Your Way to A Secure Financial Future with Global Investing’ (McGraw-Hill), and a licensed financial professional in the US and Israel. Securities are offered through Portfolio Resources Group, Inc. (www.prginc.net). Member FINRA, SIPC, MSRB, FSI. For more information, call (02) 624-0995, visit www.gpsinvestor.com or email aaron@lighthousecapital.co.il.