Why Floating-Rate Securities Make Sense in a Rising Rate Environment
Looking for higher short-term income with relatively moderate risk? A short-term bond strategy that includes floating-rate securities may be the right fit.
Advantages of Floating-Rate Securities
With the Federal Reserve signaling that it may begin to raise the federal funds rate in the next year, professional investment managers are carefully assessing the impact rising interest rates could have on investors' portfolios. One category of investment that could help fixed income portfolios weather an upward trend in rates is floating-rate securities.
Floating-rate securities offer interest payments that reset periodically based on a particular benchmark. Unlike most fixed-rate bonds, floating-rate securities will typically produce more incomes as their interest rates adjust upward. In addition, because they typically have short durations, floating-rate securities exhibit less price sensitivity to interest rate changes. That means they provide better principal protection than fixed-rate bonds—because their prices don't fluctuate as much—in addition to the income they can generate in a rising rate environment.
Floating-rate issues also enhance portfolio diversification, as their performance is not closely correlated to that of other fixed-income securities or to stocks, as evidenced by the chart below.
Rising Rates Can Generate Excess Total Return for Variable Rate Securities
Rates rising 1.00%, 2.00%, or 3.00% over six months can enhance income on variable rate securities, which stabilizes total return, while fixed-rate securities are negatively impacted.
Source: Bloomberg In this hypothetical example, both securities are three-year maturity bonds purchased at par, which are evaluated on the first semiannual payment or reset date. The example compares a fixed-rate, A-rated, corporate bond with a duration of 2.85 years and an annual coupon of 3.00% to an investment-grade, corporate floating-rate bond yielding 2.00% with a duration of 0.50 years that tracks the six-month LIBOR rate (currently near 0.45%) with a reset spread of 1.55%. Six months after the original purchase of both bonds interest rates rise. This example is for illustrative purposes only and does not represent the actual performance of any Calvert security held in any Calvert Fund.
A Quality Advantage Over Bank Rate Notes
Floating-rate securities are generally investment-grade in quality, tend to be highly liquid, and are issued by a wide range of corporations and governmental entities. Investors should no confuse them with senior secured bank loans, especially since many funds with "floating rate" in their name do invest mainly in senior secured bank loans, which are mainly below invest-grade securities. There are a few key distinctions to keep in mind:
- Bank loans are usually rated below investment-grade, meaning they carry higher credit risk than investment-grade floating-rate bonds.
- Since they are all issued by the banking sector, funds that focus on them may lack sector diversification.
- Bank loans generally have restricted liquidity.
Knowing the Risks
As with any investment, there are certain risks associated with floating-rate securities:
- Credit risk: Issuers may default or experience a credit downgrade.
- Interest-rate risk: When rates go down, the income payments from these securities typically decrease. Accordingly, the monthly distributions of funds that invest in floating-rate securities are expected to vary with fluctuations in market interest rates and may decline.
- Interest rates not going up: A variable-rate security's benchmark may remain static for long periods, potentially leading to lower total return than anticipated.
- Risks of asset-backed securities: Some floating-rate securities are backed by large pools of assets that may face the risk of default or later repayment of principal than expected.
How Floating-Rate Securities Enhance Calvert's Short-Term Bond Strategy
Calvert's short-term bond funds maintain a strategic allocation to floating-rate securities, which may provide higher total return than fixed-rate short-term bonds in a rising rate environment.
The majority of floating-rate securities held by Calvert's short-term bond funds are investment-grade bonds from a diverse range of issuers, including corporations, government agencies and municipalities, with only minimal exposure to senior secured bank loans.
With their strategic allocations to floating-rate securities, Calvert Ultra-Short Income Fund (CULAX) and Calvert Short Duration Income Fund (CSDAX) may be suitable options for investors who are looking for additional income and total return potential, while actively managing interest rate risk.