PM Perspectives: As Rates Rise, Floating-Rate Instruments May Provide Income Potential
As a supportive economy encourages the Federal Reserve to continue raising rates, Portfolio Manager Seth Meyer discusses how it’s possible to generate income without adding unduly to risk by including more floating-rate instruments such as asset-backed securities and bank loans.
I think investors as a whole have been conditioned to avoid or think to avoid the fixed income market as a whole as rates rise. And I think there are plenty of opportunities in the fixed income market that you can exploit even as rates rise. And the other thing to consider, is just to understand why rates are rising. It has been over 10 years since we have had a Fed who has been increasing rates with the hope of actually trying to take a little steam out of a growing economy. And we finally have that. After a 10-year recovery now in the U.S. economic environment, it warrants a tightening Fed. I think there are plenty of opportunities through bottom-up, fundamental work that you can find opportunities out there that provide you with the income that you would achieve while tamping the volatility
I think that the key to managing fixed income risk and fixed income is define those asset classes that will adjust up as rates go higher potentially. And the asset-backed market allow for that type of ratcheting up. Generally speaking, they are floating rate instruments, so as rates go higher, you get paid a little more in interest. But the other thing that intrigues us in environments where rates are rising and the reasons are good, meaning it is because the economy is actually strong or the world economy is strong, are finding those stories that you can actually leverage on a strengthening economy. As the economy is improving, generally speaking, so is the consumer. So if non-farm payrolls are declining, if wages are increasing, if the consumer is feeling better about themselves from a consumer confidence perspective, all of those things are great for consumer asset-backed securities. Generally speaking, these securities are shorter in duration, so the length of time between when they are issued and when they are paid off is generally short and they are paid back very quickly.
I think that not only on the ABS side can you shorten duration, but you can also just shorten duration by buying a shorter-duration corporate bond. So instead of buying the 10-year bond that XYZ Company issues, you buy a two- or three-year bond from that same company. What that will provide you is it will eliminate a lot of the interest rate risk that you inherently have by going out on the curve to a 10-year or 20-year or 30-year bond, but it will also allow you to continue to clip a relatively stable income. The other advantage to that is as those bonds mature, you get to take those proceeds and reinvest them into the next bond that either is maturing or if you think the time is right to go out further on duration, if you think it is necessary. So you can dampen duration numerous ways and one of them is just simply by buying the bonds on the front end of the capital stack. You are clearly giving up some yield to go shorter on the curve than you are the longer bonds, but sometimes giving up that yield just to dampen the volatility makes a lot of sense.
Bank loans provide a couple of advantages, one being the floating rate. So as I mentioned before, as rates go higher, generally speaking, you are getting a higher yield by owning a bank loan. The second ancillary benefit to a bank loan is they are secured. So you get to dampen the volatility of not owning an unsecured piece of paper that may be and will experience a little more price volatility than the bank loan itself, so you get to move up, get a floating rate instrument, get something that is secured, but also use the analysts’ work that we are already doing on the unsecured part of the capital structure and just apply it to the bank loan side. So if you think about when rates are rising, generally speaking, the economy is doing well. If the economy is doing well, the underlying company that you are buying that bank loan from is more than likely having earnings that are going up and not down. That is in accretive environment to be long securities in those types of companies, it dampens the volatility from not owning the unsecured bond, it allows you to get more secured in the capital structure.
I think that investors are conditioned to believe like I mentioned earlier that when rates go higher, it is generally bad for the fixed income market. I think that through solid bottom fundamental work, you can find ideas even in rising rate environments that are going to provide you with risk-adjusted returns through market cycles.
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Fixed income securities are subject to interest rate, inflation, credit and default risk. As interest rates rise, bond prices usually fall, and vice versa. High-yield bonds, or “junk” bonds, involve a greater risk of default and price volatility. Foreign securities, including sovereign debt, are subject to currency fluctuations, political and economic uncertainty, increased volatility and lower liquidity, all of which are magnified in emerging markets.
Bank loans often involve borrowers with low credit ratings whose financial conditions are troubled or uncertain, including companies that are highly leveraged or in bankruptcy proceedings.
Investments in asset-backed securities are subject to both extension risk, where borrowers pay off their debt obligations more slowly in times of rising interest rates, and prepayment risk, where borrowers pay off their debt obligations sooner than expected in times of declining interest rates. These risks may reduce returns. In addition, investments in asset backed securities may be subject to a higher degree of credit risk, valuation risk, and liquidity risk than various other types of fixed-income securities.