A few weeks ago, we discussed interest rates, the 10-Year Treasury Notes and short-term bonds. We briefly mentioned floating rate bonds, a subject to which we return today.
To review, in a rising interest rate environment, bonds will lose value. Why? Investors want the best yield possible. If interest rates are rising, investors interested in buying bonds will want new bonds that offer higher interest payments (coupons) rather than older bonds with lower interest payments.
How does the bond market adjust the value of previously issued bonds in a rising interest rate environment? By discounting (i.e. reducing) the value of the bond today. Investors will pay less for these lower-paying bonds. This market-driven adjustment facilitates the orderly functioning of the bond market. If this process did not occur, there would be no market for older bonds in a rising interest rate environment.
What are bond investors to do? They do not want to lose money in an asset class (bonds) that is intended to reduce risk in a portfolio. But if they buy bonds when interest rates are rising, they may find that the value of their bonds has gone down.
Enter floating rate bonds. These bonds have a variable interest rate. The rate is tied to a benchmark such as the US Treasury, LIBOR (London Interbank Offered Rate), the federal funds rate, etc.
Floating rate bonds, also known as “floaters,” are issued by financial institutions and governments. These bonds typically have a maturity of 2-5 years. The interest rates on these bonds will be lower than other short-term bonds because they are less risky and investors “pay” for this safety by receiving less income. The rate that is paid by the issuer can adjust as often as the issuer prefers. Payments are similarly paid according to the issuer’s preference (monthly, quarterly, semi-annually or annually). Floaters may or may not be “callable” (subject to early redemption) by the issuer (source: Investopedia).
Let’s look at a couple of floating rate bond funds. The iShares Floating Rate Bond ETF (ticker symbol “FLOT”) provides exposure to US floating rate bonds. The investment objective of FLOT is to track the investment results of an index composed of US dollar-denominated, investment-grade floating rate bonds with remaining maturities between one month and five years. The one-year return for FLOT (through March 31, 2018) was 1.68% (source: iShares).
The iShares Treasury Floating Rate Bond ETF (ticker symbol “TFLO”) provides exposure to US floating rate Treasury bonds. The investment objective for TFLO is to track the investment results of an index composed of US Treasury floating rate bonds. The one-year return for TLFO (through March 31, 2018) was 1.17%.
Given that the primary role of bonds in a portfolio is to reduce risk, and secondarily to generate income, floating bonds can be an attractive way to preserve principal and earn modest returns.
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