The good, the bad and the ugly of floating-rate debt.
This article is part of a regular series of thought-leadership pieces from some of the more-influential ETF strategists in the money management industry. Today's article features Sean Clark, chief investment officer of Philadelphia-based Clark Capital Management.
Historically low interest rates, accompanied by an unprecedented investor desire for income generation, have catapulted floating-rate debt instruments to take center stage in the search for yield.
The Morningstar Bank Loan category (floating-rate debt) had net flows of $38.6 billion year-to-date through July 31, making it the No. 1 segment in 2013. Clients are looking toward alternative income sources, and bank loans have clearly captured their attention.
With interest rates poised to rise as the Federal Reserve looks likely to begin unwinding the ultra-loose monetary policy put in place at the time of the financial crisis, this class of fixed income may help protect investors from the risks associated with a rise in bond yields.
But investors must understand the unique characteristics of the floating-rate debt asset class, and the impact the current market and economic environment will have on their potential for return.
I’ll examine the benefits and risks associated with floating rates and how the current climate has led to structural changes in many of the current issues.
Floating-rate loans have a variable interest rate that is typically tied to a money-market rate index such as Libor. They carry little rate risk since the interest rate of the issue periodically adjusts as rates change, and the debt is designed to keep pace with the overall market’s rate of interest.
During periods of economic growth and rising interest rates, floating rates can help investors diversify fixed-income allocations and protect against interest-rate risk. Unlike fixed-rate bonds whose prices decline when rates rise, floating-rate debt prices have been seen to remain relatively constant.
In today’s extremely low-rate environment, most high-grade bonds are returning a zero real return when interest is adjusted for inflation. Floating rates offer a higher yield and may help investors maintain a sufficient income stream that is protected against inflation.