Indexology^® Blog

Floating Rate Instruments can make a lot of sense in a rising interest rate environment

In my May 19 blog, I mentioned two strategies that investors could consider in a rising interest rate environment. Given the recent direction of short-term interest rates, I believe the information bears repeating with updated numbers.

Interest rates have been on the march since mid-October, thanks largely to the possibility of a hike in interest rates by the Federal Reserve. In general, bonds are vulnerable to falling market prices as a result of higher rates, but there are income investments that can be used to take advantage of, rather than fall victim to, rising rates. They’re known as floating rate instruments.

What’s happening with interest rates?
The 10-year US Treasury yield rose 0.30% from Oct. 14 through Nov. 16, based largely on anticipation of the Federal Reserve’s next move.¹ Ever since the Fed drove the federal funds interest rate to near zero, the looming question has been, “Will next year finally be the year that the Fed raises rates?” In 2015, that question changed slightly but crucially to, “Will this year finally be the year that the Fed raises rates?” With possible liftoff this December, markets are more responsive (i.e., volatile) to every economic release—and investors are carefully parsing every statement from Fed Chair Janet Yellen.

Enter floating rate instruments
When rates rise, bond prices fall. The math behind this basic bond equation is premised upon a security’s fixed coupon payment. However, with a floating rate instrument, coupons are not fixed — they rise and fall based on an underlying benchmark, typically resetting every three months based on 90-day Libor. As a result, two things happen.

1. Income and cash flow can rise as interest rates are rising (and fall if rates are declining). This can help preserve investor purchasing power if higher rates are accompanying rising inflation expectations.
2. Prices for floating rate instruments tend to be more stable. Since cash flows are only “locked” until the coupon’s next reset date, price volatility as a result of interest rate changes can be a fraction of what is experienced with fixed rate investments.

Two floating rate ideas for today’s market

1. Senior loans –Senior loans, also known as bank loans, are generally structured with floating rate coupons based on a spread over 90-day Libor. As such, interest rate risk tends to be measured by the number of days until the next rate reset, rather than the more traditional measure of duration used for fixed rate investments. Investors who are looking for exposure to high yield bonds, but are concerned about rates might prefer senior loans — most senior loans are to issuers rated below investment grade, yet these instruments have very low interest rate exposure.

2. Floating rate or “fixed to float” preferred securities –Investors have flocked to preferred securities in pursuit of higher income, but may not be aware of the significant rate risk imbedded in fixed rate preferreds. But not all preferreds are built alike. Floating rate preferred securities (or “floaters”) have coupons that reset periodically, typically based on a spread over 90-day Libor. “Fixed to float” preferred securities carry a fixed coupon for a set period of time (typically between five and 10 years), then convert to a variable rate structure. Interest rate risk is measured based on the amount of time until the next rate reset. As such, floaters have very low rate exposure. Meanwhile, fixed-to-float preferreds should experience measurable but diminishing volatility as a result of rate fluctuations during the fixed rate period of their life cycles. Both floaters and fixed-to-floating-rate structures tend to offer lower rate risk than fixed preferreds:

Conclusion
The rate path remains far from clear, but recent upward pressure on yields may have investors looking to decrease their interest rate exposure. Floating rate structures offer investors the opportunity to participate in, rather than fall victim to, a rising rate environment.
1 Source: Bloomberg as of Nov. 23, 2015

Important information
The S&P/LSTA U.S. Leveraged Loan 100 Index is representative of the performance of the largest facilities in the leveraged loan market.
The BofA Merrill Lynch US High Yield Index tracks the performance of US dollar-denominated, below-investment-grade corporate debt publicly issued in the US domestic market.
The Barclays U.S. Aggregate Bond Index is an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.
The Wells Fargo^® Hybrid and Preferred Securities Floating and Variable Rate Index is a market capitalization-weighted index designed to track the performance of preferred stock, as well as certain types of “hybrid securities” that are functionally equivalent to preferred stocks, that are issued by US-based or foreign issuers and that pay a floating or variable rate dividend or coupon.
The BofA Merrill Lynch Core Plus Fixed Rate Preferred Securities Index tracks the performance of fixed rate, US dollar-denominated preferred securities issued in the US domestic market. Securities must be rated at least B3 (based on an average of three leading ratings agencies: Moody’s, S&P and Fitch) and must have an investment-grade country risk profile (based on an average of Moody’s, S&P and Fitch foreign currency long-term sovereign debt ratings.
The BofA Merrill Lynch Adjustable Rate Preferred Securities Index tracks the performance of US dollar-denominated, investment-grade, floating rate preferred securities publicly issued in the US domestic market. Qualifying securities must have an investment-grade rating (based on an average of Moody’s, S&P and Fitch) and must have an investment-grade-rated country of risk (based on an average of Moody’s, S&P and Fitch foreign currency long term sovereign debt ratings).
Libor, or the London Interbank Offered Rate, is a benchmark rate that some of the world’s leading banks charge each other for short-term loans.
Interest rate spread is the difference between the average yield a financial institution receives from loans and the average rate it pays on deposits and borrowings.
Relative value refers to the value of one investment relative to another.
Floating rates are interest rates that are allowed to move up and down with the rest of the market or along with an index.
Duration is a measure of the sensitivity of the price of a fixed income investment to interest rate changes.
Effective duration is a measure of the sensitivity of the price of a fixed income investment to interest rate and bond cash flow changes.
Strip yield removes the accrued dividend from the yield calculation, offering a more accurate picture of the current yield (bond interest/coupon divided by the market price).
Yield-to-maturity is the rate of return anticipated on a bond if held until the end of its lifetime.
Diversification does not guarantee a profit or eliminate the risk of loss.
There is a risk that the value of the collateral required on investments in senior secured floating rate loans and debt securities may not be sufficient to cover the amount owed, may be found invalid, may be used to pay other outstanding obligations of the borrower or may be difficult to liquidate.
Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.
There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The fund’s return may not match the return of the underlying index. Please see the current prospectus for more information regarding the risk associated with an investment in the fund.
Most senior loans are made to corporations with below investment-grade credit ratings and are subject to significant credit, valuation and liquidity risk. The value of the collateral securing a loan may not be sufficient to cover the amount owed, may be found invalid or may be used to pay other outstanding obligations of the borrower under applicable law. There is also the risk that the collateral may be difficult to liquidate, or that a majority of the collateral may be illiquid.
Variable- and floating-rate securities may be subject to liquidity risk, there may be limitations on the fund’s ability to sell securities. Due to the features of these securities, there can be no guarantee they will pay a certain level of a dividend and such securities will pay lower levels of income in falling interest rate environment.

Since the introduction of ETFs, the dynamics of investing has changed dramatically. Apart from being more transparent, with lower costs and improved tax efficiency, ETFs have helped create the opportunity for smaller investors to access asset classes previously available only to institutional investors. Emerging markets tend to be riskier than developed markets, but can also offer diversification opportunities. With emerging market ETFs, it has become possible to incorporate the objectives and constraints of investors who desire exposure to emerging markets in their portfolio construction process. Among emerging markets, India has been one of the preferred countries. The assets under management (AUM) and the number of the ETFs that provide exposure to India have increased tremendously. All of these ETFs are based on Indian equities. As of July 2015, there were 27 of them, with combined AUM of USD 12.80 billion, domiciled across seven countries (see Exhibit 1). The U.S. has been the greatest contributor in terms of both AUM and the number of ETFs, followed by France, Singapore, and other countries. Since August 2015, the combined AUM has decreased by more than USD 2.27 billion, amounting to a decline of almost 18%, and it stood at USD 10.53 billion as of September 2015. This reduction in AUM has also contributed to the volatility of the equity market and the exchange rate in India.

Exhibit 1: International Equity ETFs That Provide Exposure to India

Source: Morningstar. Data as of Sept. 30, 2015. Chart is provided for illustrative purposes. 

As opposed to the international Indian ETFs, India’s domestic ETFs are not only limited to equities. They also include commodities, fixed income investments, and money markets (see Exhibit 2). As of September 2015, the total number of domestic ETFs was 51, and the combined total AUM stood at USD 2.09 billion. The proportion of domestic equity ETFs in the combined total AUM was almost 48%, at USD 1.00 billion as of September 2015. The AUM of the domestic equity ETFs in India account for just 10% of that of the international equity ETFs that provide exposure to India. The recent rise in AUM of India’s domestic equity ETFs can be attributed to the introduction of the Central Public Sector Enterprise (CPSE) ETF, as well as the investment by the Employees’ Provident Fund Organization (EPFO). The Central Board of Trustees (CBT), the apex decision-making body of the EPFO, has recently decided to invest in India’s domestic equity ETFs within the prescribed limit of 5%-15% of the total corpus.

Exhibit 2: Domestic ETFs in India 

Source: Morningstar, Association of Mutual Funds in India and Reserve Bank of India. Data as of Sept. 30, 2015. Chart is provided for illustrative purposes.

The S&P BSE SENSEX, India’s heavily tracked bellwether index, is designed to measure the performance of the 30 largest, most-liquid, and financially sound companies across key sectors of the Indian economy. As of September 2015, it has served as the underlying index to one international equity ETF, which provides exposure to India, and five domestic Indian equity ETFs. Over the past 10 years, ending in September 2015, the S&P BSE SENSEX has yielded an annualized total return of 13.32% in Indian rupees (see Exhibit 3). Apart from domestic Indian equity ETFs based on other indices, the EPFO will also invest in the domestic S&P BSE SENSEX ETF, leading to expectations of a further boost to the AUM of this established index.

Source: S&P Dow Jones Indices. Data as of Sept. 30, 2015. Chart is provided for illustrative purposes. Past performance is no guarantee of future results. 

This morning’s Wall Street Journal interviews Peter Lynch, the legendary and erstwhile manager of the Fidelity Magellan Fund, who, unsurprisingly, turns out to be an advocate of active equity management.  “People accept that active managers can’t beat the market and it’s just not true,” says Mr. Lynch, who certainly did beat the market in his day.

In support of this view, we learn that “a Fidelity spokesman says about three-quarters of its 49 equity funds managed by the same portfolio manager for at least five years were beating their benchmark over the manager’s tenure…”  A casual perusal of Fidelity’s website reveals a total of 110 actively-managed equity funds (41 U.S., 25 international, and 44 sector-specific), which means that less than half have had the same manager for five years.  If Fidelity wished to do so, they could implement a policy of changing the manager of any fund which hadn’t outperformed over the manager’s tenure (perhaps after a five-year probationary period).  Then their spokesman could announce that 100% of the funds managed by the same portfolio manager for at least five years had beaten their benchmark.  It would be a more impressive sound bite, but just as meaningless a statement about the nature of active management.

Otherwise said: suppose two new portfolio managers take over new funds this year, and after four years one is outperforming her benchmark while the other is underperforming.  Which of the two do you think has the better chance of making it to year five?  The Fidelity statistic is a classic illustration of survivorship bias.  When we control for survivorship, as in our SPIVA reports, the majority of active managers underperform most of the time.

What is true across the population of active managers does not mean that individual managers cannot be exceptions.  Indeed, Peter Lynch is famous precisely because his performance was exceptional.   If most active managers could outperform consistently, we wouldn’t celebrate the few who do.

As the Puerto Rico municipal bond saga continues it may be helpful to look at how other distressed municipal bonds have performed through Friday December 4th 2015.

The S&P Municipal Bond Default Index tracks municipal bonds that have entered default by not paying all or part of the promised principal or interest when due.  It currently tracks over 250 bonds with a par value of over $5.4 billion.   Within the index there are several sectors which have historically had the majority of defaults take place.  Those sectors are the  land backed, health care, corporate Backed and multifamily sectors.

Table 1: Municipal bond indices tracking defaulted bonds:

So far, the S&P Municipal Bond Default Index is in negative territory with a return of -1.54%.  Corporate backed municipal bonds have seen a positive return of over 5.4%.  Smaller sectors such as the health care and multifamily sectors have seen significant negative results with health care bonds being crushed by over 35% in 2015.

If and as the Puerto Rico bonds default it can be expected that they will be added to the S&P Municipal Bond Default Index during a monthly index rebalancing and if they do they may have a significant weight in this index.

The junk or high yield bond markets in the U.S. have seen diverse returns so far in 2015.  Municipal junk bonds are out performing both the senior loan and fixed rate corporate high yield segments of the market.  While municipal bonds are being buffeted by Puerto Rico corporate bonds and loans are seeing more significant head winds.

Table 1:  Select indices tracking below investment grade segments of the debt markets.

When looking a little deeper into  ratings categories within these segments the municipal bond market has continued to shine.  Starting with the investment grade BBB ratings category, municipal bonds have had a return of nearly 3.5% year-to-date while the large entities tracked in the S&P 500 BBB Investment Grade Corporate Bond Index has recorded a negative 0.46%.  Moving into the below investment grade category of BB+ and below municipal bonds are still outpacing their corporate counterparts.  The BB quality range is being impacted by energy bond issues, such as those from Chesapeake Energy, which are playing a big role in dragging down the corporate bond junk sector in 2015.

Table 2: Select indices representing specific ratings categories of the debt markets.