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With the Federal Reserve prepared to potentially raise interest rates as early as later this year, fixed-income investors have grown increasingly nervous and are now looking for the best way to protect against interest rate risk. Could floating-rate bond funds be the solution?
If you’re not clear on interest rate risk, the explanation is essentially straightforward.
- Bond prices and interest rates have an inverse relationship.
- When interest rates rise, the new bonds coming to market have higher yields than older securities. That makes the prices of newer bonds go down.
- Conversely, when interest rates decline, the new bonds coming to market have lower yields than older securities. That makes the prices of newer bonds go up.
Therefore, if you have to sell your bond before maturity, it may be worth more or less than you paid for it.
Most bond funds will experience the same declines in value as interest rates rise. But some bond fund categories, such as those that are longer in maturity and/or lower in relative credit quality, will have steeper declines than others. These are said to have high interest rate sensitivity.
But are there bonds and bond funds that can hold their value or even rise in price along with rising interest rates?
How Floating-Rate Bond Funds Work
Floating-rate bond funds are getting more attention recently because of the increasing fear of the end of the decades-long bull run for bond prices.
Floating-rate bonds – also called bank loans, floating-rate notes or “floaters” – adjust on a regular basis and the respective interest rate is commonly tied to the LIBOR (the London Interbank Offered Rate), not the more widely watched 10-year Treasury yield or federal funds rate.
Although the LIBOR won’t exactly move in tandem with the Fed’s rate policy changes, it can lead to changes in the federal funds rate and can therefore be viewed as a more accurate reflection of global interest rates.
Is Now a Good Time for Floating-Rate Bond Funds?
The bond market is arguably more complex and less understood than the stock market. Fixed-income investors have been worried about rate increases for at least two years and have been wrong.
Floating-rate bond funds will likely prove their worth in an environment of sustained increases in the LIBOR, which may or may not transpire the way even the most knowledgeable and experienced bond fund managers or economists can predict.
But like any other investment decision or strategy, it is wise to resist market predictions and maintain a diversified approach to portfolio management. Therefore, it is impossible to know if floating-rate bond funds are a good bet now or not. However, they can be a smart addition to a diversified fixed-income portfolio, and investors can also avoid the bonds and bond funds with high interest rate sensitivity, such as the long-term and high-yield areas.
If you’re looking for a floating-rate bond fund with an experienced management team, you might try mutual funds like Metropolitan West Floating Rate Income Fund (MWFRX) or T. Rowe Price Floating Rate Fund (PRFRX). If you want to go the ETF route, you can consider the oldest and most popular bank-loan exchange-traded fund: PowerShares Senior Loan ETF (NYSEArca: BKLN).
As of this writing, Kent Thune did not hold a position in any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.
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