With the recent upswing in inflation and economic growth, bond investors are getting more concerned about the stress this may have on bond prices and their overall portfolios.
Should they be worried? Here are a few general items affecting interest rates we DON’T yet know:
-How much stronger will US GDP get?
-How far above the Fed’s 2% mark will inflation travel?
-How many times will the Fed raise interest rates?
-How high will the Fed funds top out at?
-When will another US recession start?
Though most fixed income investors are keenly aware of the above questions and uncertainties, they can, however, be positioned to benefit from an increase in rates through Floating Rate Bonds (FRBs).
Here are some things to consider:
- FRBs can come in taxable corporates or tax-free municipal form.
- Some start as a fixed-rate bond for a specific period then floats to the three-month LIBOR rate plus a margin and some floating rate at the beginning.
- Most can be called at the initial float date and any quarterly adjustment date thereafter.
- Price and yield can be sensitive to declining rates depending on the economic cycle.
Let’s look at an example of how this would work (note: for illustrative purposes, all bonds are from fictitious companies and are investment-grade in quality).
Anacot Steel has just issued a floating rate bond with the following characteristics:
- 5.95% fixed coupon until 2027 at which time it can be called.
- From 2027 onward it will float to three-month LIBOR plus 4.00%.
Hypothetically, let’s say the three-month LIBOR rate is sitting at 3%. So, for the next three months, Anacot Steel must pay an annualized rate of 7% or it has the option of retiring the issue.
Let’s look at another company, Blue Horseshoe Industries, which will float this month with the following characteristics:
- Floats to 3-month LIBOR + 3.59%.
- The issuer can call the bond at any interest pay date at par.
The current three-month LIBOR rate is 1.15%. For the next three months, the holder will receive a current yield of 4.74%.
Now for something completely different. Let’s look at Blue Star Airlines (BSA). Back in the mid-eighties BSA issued an FRB with the following characteristics:
- Initial fixed coupon rate of 5.75%
- Floating rate is 3-month LIBOR plus 1.11% with a 5.15% floor.
From the date of issue, BSA is stuck paying a minimum of 5.15% or they can retire the issue. Notice in the graph below how closely the LIBOR rate follows the Fed funds rate.
Source: Bloomberg
Another strategy would be to develop a laddered bond portfolio, say a ten-year ladder with bonds maturing every two years. Therefore, in a rising rate environment, fresh cash is available every two years to put toward higher rates should they occur thus keeping your ten-year ladder intact.
Though we've used a hypothetical example, should inflationary pressures continue, the prospect of further rate hikes will have a real impact on bond prices. Using floating rate bonds is one way to position yourself and increase income in a rising interest rate environment.
For more information, please contact Robert Bernard @ 858-487-3939 or by email rob[dot]bernard[at]financialsense[dot]com[dot]com.
