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Floating up when interest rates rise

Floating rate loans offer some protection against rising rates, but beware of price.

  • Fidelity Asset Management
  • – 03/23/2014
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With the recent volatility in interest rates, income investors may be starting to worry about the risk of sustained rate increases from today’s historically low levels. Over the past few years, many investors have reached for yield through longer-dated investment-grade bonds. But the price of longer-duration bonds, in particular, can be negatively affected by interest rate increases. Another option for those looking for yield is to consider high-yield bonds—higher interest rate bonds from companies with lower credit ratings. But some investors hesitate to take on the additional risk of high-yield bonds—particularly if prices look high.

What’s an income investor to do? Some possible help may be found in an asset class that combines features of both the short-term fixed income market and the high-yield market: non-investment-grade floating-rate loans. As of January 31, 2014, the majority of floating-rate notes were trading near or above par—meaning these securities appeared relatively high priced. But even if price gains seem unlikely, these securities may still play a role in a diversified fixed income portfolio, particularly if you are concerned about rising rates.

Floating-rate basics

A tricky market

Floating-rate loans generally are subject to restrictions on resale, and they sometimes trade infrequently in the secondary market. As a result, they may be more difficult to value, buy, or sell. A floating-rate loan might not be fully collateralized, which may cause it to decline significantly in value.

Floating-rate loans have an adjustable rate that goes up—or down—with short-term interest rates. The spread on floating-rate loans is set as a fixed amount above a standard rate such as the London Interbank Offered Rate (LIBOR), which is a widely used benchmark for short-term lending among banks. If the LIBOR rises, so does the interest rate on the floating-rate loan. That means that floating-rate loan investors have the potential to enjoy higher coupon payments if rates rise. And it also means that interest rate increases have little impact on the prices of floating-rate loans—a big difference from conventional bonds. While most floating-rate notes have the same basic structure, there are important differences from one issue to another. For example, the base index rate is often the LIBOR but can vary. In addition, maturity, payment periods, and reset periods will change from one note to another—all of which can affect the investment’s price and reaction to interest rate changes.

"While it’s unclear exactly when or how much rates may rise, for investors who are concerned about interest rate risk and who are willing to take on increased credit risk from securities that are typically rated non-investment-grade, floating-rate loans are an important option to consider," says Eric Mollenhauer, portfolio manager of Fidelity® Floating Rate High Income Fund (FFRHX). "The combination of yields that are higher than those offered for more conservative short-term investments, together with the floating-rate feature, may make these securities an attractive part of a diversified portfolio. But when the market looks expensive—as in recent months—it’s important to exercise caution and perform serious research when picking particular investments. And given the risks of these investments, consider diversified portfolios of these securities, and think about where they fit into your overall portfolio."

A higher-yield/higher-risk option

All else being equal, floating rate loans are typically higher-yielding than most investment-grade short-duration investments because they have lower credit quality.

The historical default rate for floating-rate loans is about 3.4%, versus 0.1% for investment-grade bonds and 5.0% for high-yield bonds, according to research by Moody’s. One protection investors enjoy with floating-rate loans is that floating-rate loans sit at the top of the firm’s capital structure. In case of default, they are paid back before bondholders. While that may reduce the risk that investors in floating-rate loans will not be paid back,  it doesn't eliminate it—some portion of floating-rate loans have historically defaulted.

Mollenhauer says that today’s low interest rates may help keep defaults at bay. “Low interest rates use up less of a company’s cash flow,” he notes, “so these companies are generating more free cash flow than they were before. And that makes them a little healthier.” In the floating-rate loan market as a whole, Mollenhauer adds, “credit quality is still pretty good.”

A pricey market

Still, Mollenhauer notes that strong demand has bid prices higher. “Almost 80 percent of the market is now trading above par,” Mollenhauer says. “It’s definitely a market where the loan issuers have more control, given the strong demand for loans. That means it’s time to be conservative. I am looking to take some risk out of the portfolio and wait for opportunities to pick up some credits a little cheaper down the road.”

All the same, Mollenhauer thinks the market retains its appeal. Both the high-yield bond and leveraged loan markets have been affected by investors looking for yield in a low interest rate environment. “A lot of what’s driven the floating-rate loan market up, in terms of investors looking for yield, has driven the high-yield market up as well.” This has caused the spread between the yields of the two asset classes to compress, and has made floating-rate loans look pretty attractive compared with high-yield bonds,” he says. “Even if spreads come down, there is some comfort in being on top of the capital structure, with floating-rate loans secured by the company’s assets. At some point in the next 10 years, I would have to guess, rates are going to rise, and if that happens, you could start to benefit from the floating-rate component alone.”

Floating-rate in today’s market

Depending on one’s risk tolerance and needs, floating-rate loans may make sense as part of a larger fixed income strategy. Floating-rate loans are held by institutional investors. Individual investors can own these securities by investing in floating-rate loan mutual funds (sometimes called bank loan funds) or exchange-traded funds (ETFs). This asset class may play a useful role for risk-tolerant income investors who seek higher yield from non-investment-grade short-duration securities—while also offering some protection for those who think rates will rise in the future. In addition, floating-rate loans can offer diversification benefits for long-term investors because of the loans’ low correlations to traditional asset classes like stocks and investment-grade bonds.

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Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.
Past performance is no guarantee of future results.
Diversification cannot ensure a profit or protect against a loss.
In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.
High-yield/non-investment-grade bonds involve greater price volatility and risk of default than investment-grade bonds.
Floating-rate loans generally are subject to restrictions on resale, and they sometimes trade infrequently in the secondary market. As a result, they may be more difficult to value, buy, or sell. A floating-rate loan might not be fully collateralized, which may cause it to decline significantly in value.
The views and opinions expressed by the Fidelity speaker are those of their own, as of March 26, 2014, and do not necessarily represent the views of Fidelity Investments or its affiliates. Any such views are subject to change at any time based on market or other conditions, and Fidelity disclaims any responsibility to update such views. These views should not be relied on as investment advice and, because investment decisions are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity product. Neither Fidelity nor the Fidelity speaker can be held responsible for any direct or incidental loss incurred by applying any of the information offered. Please consult your tax or financial adviser for additional information concerning your specific situation.
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