Elevated LIBOR creates opportunities in floating rate bonds

What investors need to know about these bonds in a rising rate environment

Elevated LIBOR creates opportunities in floating rate bonds

Time to read: 3 min

We believe the recent spike in US dollar LIBOR (LIBOR) presents opportunities in floating rate bonds. As noted in the recent blog (What’s up with US dollar LIBOR?), we at Invesco Fixed Income believe three factors have driven LIBOR higher:

  • The US Federal Reserve (Fed) has pushed monetary policy rates higher with its latest hike in March.
  • Demand has fallen for short-term credit instruments due to potential corporate repatriation following last year’s tax reform.
  • Markets expect an abundant supply of US Treasury bills (T-bills) through 2019, given projected budget deficits.

Investors in floating rate bonds could benefit from this dynamic

One of the less appreciated corners of the fixed income market is floating rate bonds. The floating rate bank loan category is perhaps more well-known, but variable coupon assets are also available in high quality corporate bonds, commercial mortgage-backed securities (CMBS), residential mortgage-backed securities (RMBS), asset-backed securities (ABS) and municipal bonds.

What are they?

Floating rate bonds generally have maturities of one to five years. What differentiates them from fixed coupon bonds is that their interest rates reset every one to three months, depending on a reference rate (historically LIBOR) and an additional percentage amount, a “spread,” that reflects the credit and liquidity risk of the issuer and asset class.

As short-term rates increase, the coupon on the floating rate asset increases. The result is an asset with potentially reduced exposure to interest rate sensitivity. As a result, floating rate bonds may be an option for fixed income investors concerned about rising interest rates. Floating rate bonds tend to have a very short duration because their coupons reset. This means they are generally less sensitive to movements in longer-term interest rates.

Why consider floating rate bonds now?

For many years, short-term interest rates in the US were very low — below the rate of inflation. This may have caused investors in floating rate assets to experience a loss of purchasing power. But more recently, short-term interest rates have exceeded 2%, which, when added to the spread, represent a yield well above US inflation (Figure 1). This may draw investor attention to the floating rate market.

Figure 1: Three-month LIBOR has surpassed core inflation and is approaching headline inflation

Source: Bloomberg, L.P. Data from Dec. 31, 2014, to March 31, 2018.

In addition, the “flattening” of the US Treasury yield curve (as short-term rates have risen faster than longer-term rates) has increased the attractiveness of short-duration bonds relative to intermediate and longer-term assets. This flattening has often occurred when the Fed embarks on the process of tightening liquidity by increasing short-term rates. As the yield curve flattens and the differential between short-term and longer-term interest rates declines, investors often migrate toward the shorter end of the investment spectrum.

Issuers of debt in the investment grade market are capitalizing on this additional demand by increasing their issuance of floating rate debt, particularly within corporate bonds (Figure 2). Financial firms have also capitalized on the demand for variable coupon bonds by issuing “fixed-to-float” securities. Traditionally, fixed-to-float securities are subordinate bonds that pay a fixed rate for a stated period and convert to floating at a stated date.

Figure 2: Rising demand has driven the issuance of US corporate floating rate bonds

Rising demand has driven the issuance of US corporate floating rate bonds

Source: Bloomberg Barclays US Floating Rate Note Index. Data from April 1, 2010, to April 19, 2018.

Risks of floating rate bonds

There are risks associated with floating rate bonds. There is a risk of lower coupons if short-term rates decline from current levels. Investors in floating rate assets also do not benefit from the negative correlation to equities that typically exists with longer-duration bonds. Finally, financials tend to make up a significant portion of the corporate floating rate market, which can lead to concentration risk in portfolios.

However, Invesco Fixed Income believes that floating rate bonds may be a good option to consider for investors seeking to benefit from a rising interest rate environment.  If current expectations of Fed rate hikes hold true, the coupons on floating rate securities may continue to reset higher as short-term interest rates increase, potentially increasing income.

Investors interested in funds that invest in floating rate bonds may want to consider Invesco Conservative Income Fund, PowerShares Ultra Short Duration Portfolio and PowerShares Variable Rate Investment Grade Portfolio.

Important information

Blog header image: Creative Photo Corner/Shutterstock.com

The Bloomberg Barclays US Floating Rate Note Index measures the performance of US dollar-denominated, investment grade, floating rate notes across corporate and government-related sectors.

The consumer price index (CPI) measures change in consumer prices as determined by the US Bureau of Labor Statistics. Core CPI excludes food and energy prices.

LIBOR (London Interbank Offered Rate) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. US LIBOR represents LIBOR denominated in US dollars.

Spread represents the difference between two values.

Correlation is the degree to which two investments have historically moved in relation to each other.

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity. A flat yield curve is one in which there is little difference in the yields for short-term and long-term bonds of the same credit quality. In a normal yield curve, longer-term bonds have a higher yield.

To the extent an investment allocates a greater amount in any one sector or industry, there is increased risk to the fund if conditions adversely affect that sector or industry.

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.

Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

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.

Mortgage- and asset-backed securities are subject to prepayment or call risk, which is the risk that the borrower’s payments may be received earlier or later than expected due to changes in prepayment rates on underlying loans. Securities may be prepaid at a price less than the original purchase value.

Michael D. Hyman
CIO, Global Investment Grade & Emerging Markets

Michael Hyman is Chief Investment Officer, Global Investment Grade & Emerging Markets for Invesco Fixed Income. He joined Invesco in 2013.

Previously, Mr. Hyman was with ING Investment Management and ING Institutional Markets for 12 years. At ING, he was the head of investment grade corporate credit, responsible for investment grade corporate credit as well as collateralized loan obligation and synthetic collateralized debt obligation investment portfolios. Prior to joining ING, Mr. Hyman was a director of capital markets for GE Capital and held trading and risk-management positions at various global banks. He entered the industry in 1991.

Mr. Hyman earned a BSE degree in finance from Pennsylvania State University and an MBA from the Stern School of Business at New York University.

Steven Thompson
Senior Client Portfolio Manager

Steven Thompson is a Senior Client Portfolio Manager responsible for client-related activities across the fixed income credit spectrum with a primary focus on investment grade and multiasset strategies.

Mr. Thompson entered the industry in 1992 and joined Invesco in 2014. He previously served as a product specialist supporting investment grade, high yield, bank loans and quantitative asset allocation strategies at AEGON. He also worked at Bank of America in the US and Europe as a senior securitization professional covering bank loans, high yield bonds and asset-backed securities. While at Bank of America, he was involved with the buildout of the European cash and derivative collateralized loan obligation platform. Mr. Thompson also worked at Wachovia in a similar role.

Mr. Thompson earned BBA and MA degrees in accounting from the University of Iowa. He holds the Series 7 and 63 registrations.

More in Fixed Income
London lnterbank Offered Rate (LIBOR)
What’s up with US dollar LIBOR?

Time to read: 4 min The last time we wrote about the US dollar London lnterbank Offered Rate (LIBOR) was in 2016, when the spread...