Protecting Against Rising Rates

Floating rate notes can help cushion the impact

There is no doubt that bonds have had an unprecedented run over the past 30 years or so, as falling interest rates drove bond prices higher, rewarding investors with outsized returns along the way. Returns have moderated of late, with the majority of central banks keeping short-term interest rates on hold. Recent bond returns have been more in line with the average coupon rate, with the DEX Universe Bond Index gaining 3.6% in 2012. Barring any major movements in interest rates, we expect that we will see similar returns in 2013.

At the risk of sounding like a broken record, interest rates cannot remain at their current levels indefinitely. It is not a question of if interest rates will rise, but when. Unfortunately, predicting when the rates will start increasing has become a very difficult task.

While the economy continues to slog along, it is not growing at a pace that would require moving rates higher. Still, some signs of life are emerging. In the U.S., the housing market is improving, consumer spending is on the rise, jobs are being created, and economic growth is on the upswing. In Canada, growth is positive, but slowing to a more modest pace.

When rates do begin to rise, traditional bonds, particularly the safe haven government bonds, will be hit the hardest, taking on the full brunt of the losses. As we know, bond prices move in the opposite direction of interest rates, so if interest rates move higher, bond prices move down.

There are a few ways to help protect against this. One way is to invest in short term bonds, which aren’t affected as much when rates move. Another option is to invest in bonds that offer higher yields, for example corporate or high yield bonds, since the higher coupon payments help protect them from rising rates.

One often overlooked option to help protect against rising rates are floating rate notes. In very simple terms, floating rate notes are issued by large corporations with the coupon payment based on the prevailing rate of interest in the economy. Usually these loans are senior debt and they can be secured or unsecured. Secured notes are typically collateralized by such things as accounts receivable, inventory, property, plant and equipment. They will typically have a maturity of between 5 and 9 years.

There are a number of reasons to consider investing in floating rate notes. Because the coupon payment moves with the prevailing rate of interest, there is virtually no duration risk. Unlike other bonds, their prices won’t be negatively affected when interest rates rise. They also tend to be a good hedge against inflation.

Within the context of a portfolio, funds that invest in these notes tend to have low or even negative correlation to the traditional asset classes. For example, looking at the Trimark Floating Rate Income Fund, it has low positive correlation to the main equity indices, and is negatively correlated to the DEX Universe Bond Index. This correlation profile will help to reduce overall volatility when used as part of a well diversified portfolio.

They are not without their risks. Many of the floating rate notes available are not rated as investment grade debt by the major ratings agencies. As a result, they can carry a high risk of default. Because of this, you will want to make sure that any floating rate investment you consider is well diversified, and that the managers have a sound investment process in place.

While recent performance has been decent, these funds were hit very hard during the credit crisis of 2008. Between May and December 2008 these funds dropped precipitously with the BMO Guardian Floating Rate Income Fund dropping by 46% while the Trimark Floating Rate Income Fund fell by 27%. While nothing on the horizon suggests a similar event to be occurring, these products are likely to be hit hard again if there are any issues with liquidity in the corporate bond markets.

Floating rate notes are a fairly small segment of the investment universe and there are only a handful of ways to invest in the sector.

As of February 28, 2013, the main floating rate note funds include:

AGF Floating Rate Income Fund (AGF 4076) – AGF hired Boston based Eaton Vance to bring their successful floating rate fund to Canada. With this fund, foreign currency is hedged 100% back to Canadian dollars. Looking at the performance of the U.S. version, even accounting for the higher fees, we expect that it should be a solid performer going forward on both an absolute and risk adjusted basis.

BMO Guardian Floating Rate Income Fund (GGF 626) – One of the first funds in the floating rate space, this has rebounded nicely since taking a 46% drop in 2008. Credit quality looks strong, with more than 31% invested in notes that are rated “A” or higher. However, it has one of the more concentrated portfolios, holding around 50 names. Shorter term performance has been strong, but still the longer term numbers lag. It is also the smallest fund in the category with slightly more than $16 million in assets. Given the above, we would likely shy away from it for now.

iShares DEX Floating Rate Note Index ETF (TSX: XFR) – This is the most conservatively positioned of the floating rate products available. It is solely invested in Canadian floating rate notes. Unlike the other funds, it is heavily concentrated in government floating rate bonds, with only a modest 7% weighting in corporates. While this positioning may help in periods of uncertainty, we believe that over the long term, it will underperform its more diversified peers, even with its significant cost advantage.

Manulife Floating Rate Income Fund (MFC 4573) – One of the newer entrants in the space, it has also been the strongest performer since its launch. It is currently invested primarily in notes that are rated BBB or lower, but is very well diversified with more than 140 names to help offset this higher credit risk. Despite this greater diversification, it has been more volatile than the other funds. But, if you are comfortable with the higher risk, then this may be a good fund to consider.

Trimark Floating Rate Income Fund (AIM 1233) – This is our top pick in the space. It is the oldest fund in the category and has delivered modest longer term returns. It has also been the least volatile. It, like the BMO Guardian offering was hit hard in 2008, dropping by 27%, but has since more than made up for that decline. We believe that it should continue to be the leader in the space on a risk adjusted basis, although the Manulife fund may do better on an absolute basis.

Bottom Line: Floating rate notes can be a good way to help protect your portfolio against the impact of rising interest rates. They are not without risks, and should not be used as a core holding. Instead, use them in a way that is similar to how you would use high yield in your portfolios, keeping their exposure to a reasonable level given the total risks.