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interest rates

MAM 178: Floating Rate Bond Funds – Trading Rate Risk for Credit Risk

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It’s important to remember that eliminating one type of risk almost always results in assuming another when it comes to investing. There are no returns without some degree of risk taking. You’d know that to be true if you were tried out litecoin to bitcoin margin trading: highly lucrative but also highly volatile. Floating rate bond funds are a great example of risk elimination actually being a risk trade.

Floating rate bond funds significantly reduce one of the biggest worries of fixed income investors, interest rate risk. It’s pretty commonly known that when interest rates go up, bond prices go down. Bond rates and prices are negatively correlated. Floating rate bond funds differ from traditional bond funds because their interest rates aren’t fixed. They’re periodically adjusted based on a floating reference point, such as LIBOR or the Fed funds rate plus a built in spread. It’s typical to see these rates adjust to reflect changes every 30-90 days. Since their rates adjust to current yield conditions, their prices are not affected in the same way most bond funds are when rates rise.

A bond fund with little to no interest rate risk? Sounds too good to be true!

Let’s return to the concept of there being no returns without some degree of risk taking. What’s the catch with floating rate bond funds? In return for muted interest rate risk, these funds assume far more credit risk. Credit risk refers to the possibility that the loans making up the bond fund will not be repaid in a timely fashion (or at all).

Floating rate bond funds are notorious for serving as a source of financing for companies with poor credit. Think of smaller or midsize businesses whose credit is not good enough to issue their own bonds. This means that the loans held in floating rate funds are significantly more likely to default than those held in higher quality fixed income products. In fact, returns on floating rate funds are most highly correlated to high yield (junk) bonds.

If you’re relying on a bond allocation to lower your portfolio’s overall volatility, you may want to think twice about investing in floating rate bond funds. When credit spreads widen, these funds are at a higher default risk. This is likely to be poor timing for your bond investments to become riskier. According to Morningstar, in 2008 the average bank-loan fund lost 30% while the average intermediate term bond fund lost 4.7%. This all occurred while the S&P 500 index dropped by over 40%. If your reason for owning bonds is to diversify and have a lower overall portfolio volatility, floating rate bond funds failed pretty miserably at providing that in the last real crisis we saw.

Many investors have misused these funds in the last few years as a way to express their prediction on the direction of interest rates. Just look back to the 12 months preceding June 30, 2013 for an example: Assets in floating rate bond funds increased by more than 70% seeing inflows of $45 billion. Those numbers include the infamous taper tantrum. We’re still waiting on the great rising rate environment, and I’m not smart enough to predict when we’ll see it. If somebody knows exactly when and by how much rates will rise…by all means, take advantage and pile into floating rate bond funds for their decreased interest rate risk. Just make sure to know when rates will stop rising too so you can time you exit from them.

Investors would do well to remember that they’re always trading one type of risk for another when it comes to investing. In the case of floating rate bond funds, the trade is accepting higher credit risk for lower interest rate risk.

Sources:

https://pressroom.vanguard.com/content/nonindexed/9.2013_Floating_rate_bond_funds.pdf

http://www.wsj.com/articles/SB10001424052702303948104579535611564175746

http://www.wsj.com/articles/SB10001424052702303393804579308490476037048

The 1950’s Bond Market May Be A Template For Today

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From this awesome article on A Wealth Of Common Sense, all we need is Potsie and Fonzie!  The article draws some GREAT parallels to the current bond market and interest rate scenario we are staring down in 2015.

A line that had specific importance to us was:

“When risk strikes and stocks get hit, investors will almost certainly switch to the ‘perceived safety’ of high quality bonds.”

Bond investors are often fearful of another 1970’s type market, but with differing interest rate levels, and inflation rates, using the blueprint from the 1950’s could potentially be a much more useful tactic.  In the 1950’s, with low inflation, and slowly raising rates, bond investors did not get killed in the market.  This could be a good sign for bond investors in today’s market.  Happy days!

 

Source: 

http://awealthofcommonsense.com/the-blueprint-for-a-bond-bear-market/

Why Increased Job Creation Hasn’t Inspired More Spending

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We’ve definitely seen an increase in job creation recently. This is generally a good economic sign: more jobs being created means consumers are more willing to spend money, thus stimulating the economy. We haven’t seen this lately though, leaving many to wonder what’s up? On this week’s Mullooly Asset Management podcast, Tom and Tim discuss why more jobs haven’t necessarily translated into more spending from consumers yet.

Tom Keene and Michael McKee of Bloomberg Radio recently interviewed John Herrmann, Director of Interest Rate Strategy at Mitsubishi UFJ Securities. They spoke about the increase in job creation seen in recent years. The caveat in the otherwise encouraging numbers has been that many of the jobs are part time. It’s very true that new part time jobs are better than no new jobs, but it’s important to consider what part time work entails. Part time employment doesn’t exactly inspire the same confidence that full time employment does. Many individuals may be relieved to find work, but also may worry that during the next economic downturn they’ll be the first worker to get cut.

It would obviously be preferable if these new part time employees evolved into full timers. This won’t realistically happen for everybody though. In fact, many are worried that this new trend of part time employment will become permanent.

Where does all of this leave the American economy? To put it simply, kind of a weird place. People aren’t quite as miserable as they were 4-5 years ago, but they’re also not encouraged enough to consider spending their discretionary income on things like cruises, new furniture, new cars. etc. Credit expansion is something we look for in a recovering economy, and it’s been conspicuously absent so far.

During the interview Herrmann mentioned an interesting point about new job creation. The age group benefiting the most from increased job creation has been those age 50 and above. Let’s think about this demographic generally for a moment. On the whole, are those age 50 and above spenders or savers? We’d venture to say they’re probably savers. Most people in their fifties already have a home, furniture, cars, etc. They aren’t as likely to provide the type of spending we need to see economic growth. Individuals who are over 50 are more likely to use their discretionary income to pay down existing debts.

How does all of this fit into the “when will the Fed raise rates?” discussion? The Fed has said it’s looking for wage growth to improve along with a decrease in the unemployment rate. Wage growth did budge a bit recently, but inflation remains low. The general consensus seems to be that while the Fed may be raising rates sometime this year, it’s likely to be at a much slower pace than they’ve done in the past. Only time will tell the story, as nobody can predict the future. We found Herrmann, Keene and McKee’s breakdown of new job creation enlightening though, and hope you do too!