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Market View

Historically, floating-rate notes have generated positive returns despite rising rates, and they offer the potential for higher income going forward.

 

In Brief:

  • Against a backdrop of volatile U.S. markets and rising rates, investment-grade floating-rate notes (FRNs) have provided relative stability and rising income.
  • Recent increases in short-term interest rates have created the potential for FRNs to generate higher income going forward.
  • Ultra-short bond strategies that combine floating-rate notes with other short-term securities can be a source of potential portfolio stability amid market volatility.

 

After a period of relative calm, U.S. markets have witnessed increased volatility in 2018, both in equities and in interest rates. Specific to the bond market, yields on the benchmark two-year U.S. Treasury note and the 10-year U.S. Treasury bond have increased by 47 basis points (bps) and 40 bps, respectively, year to date (as of April 13, 2018). This has led to negative returns in most segments of the bond market this year (see Table 1).

 

Table 1. Longer-Duration Assets Are Feeling the Impact of Rising Rates
Data year to date, as of April 12, 2018

Source: Bloomberg Barclays, ICE BofAML. Investment-grade floating-rate notes represented by Bloomberg Barclays Investment-Grade Floating-Rate Note Index. High yield represented by ICE BofA ML U.S. High Yield Index. U.S. Treasury (1-5 years) represented by Bloomberg Barclays U.S. Treasury (1-5 year) Index. U.S. Treasury represented by Bloomberg Barclays U.S. Treasury Index. The historical data shown are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Past performance is not a reliable indicator or guarantee of future results.

 

Asset classes with limited duration exposure have performed the best. For example, floating-rate bank loans (as measured by the Credit Suisse Leveraged Loan Index) are up 1.80% year to date. Within investment-grade fixed income, one segment that has provided relative stability has been investment-grade floating-rate notes (FRNs).

FRNs are bonds issued by investment-grade companies with floating-rate coupons, typically based on a spread over a short-term benchmark rate, such as the three-month London interbank offered rate (Libor). Unlike a traditional fixed-rate bond, where the coupon is constant over the life of the bond, the coupons on FRNs will reset, generally every three-month period, and adjust up and down with moves in Libor. As a result of this structure, floating-rate notes have lower duration and less interest-rate sensitivity than longer-duration fixed-rate bonds. This also leads to lower volatility than longer-duration assets, and greater price stability during periods of rising rates. (These FRNs are not to be confused with bank loans, which also have floating-rate coupons tied to Libor, but primarily are a below-investment-grade asset class.)

Rather than just looking at this year-to-date period, a slightly longer-term view can help illustrate the benefits of FRNs. Chart 1 summarizes the monthly performance of the Bloomberg Barclays Investment Grade Floating Rate Note Index ("FRN Index") since July 2016, which coincides with the recent low point in the 10-year Treasury bond. Since early July 2016 (when the markets were spooked by the surprise “Brexit” vote), yields on the two-year Treasury note and 10-year Treasury bond have increased by approximately 180 bps and 150 bps, respectively. Despite this rise in rates, the FRN Index has generated positive returns in each month. The U.S. Treasury Bill Index (“T-Bill Index”), which also has very little duration exposure, has also been positive each month. But given the higher coupon income, FRNs have generated higher total returns. In fact, as of April 12, 2018, over the trailing year the FRN Index has generated twice the total return of the T-Bill Index (2.18% versus 1.09%).

 

Chart 1. Historically, Floating-Rate Notes Have Generated Positive Returns Amid Rising Rates
Monthly returns versus Treasury bills, July 2016–March 2018

Source: Bloomberg Barclays and ICE BofAML. Floating rate notes represented by Bloomberg Barclays Investment-Grade Floating Rate Note Index. Short-term rates represented by ICE BofAML U.S. Treasury Bill Index. The historical data shown are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Past performance is not a reliable indicator or guarantee of future results.

 

While FRNs have generated positive returns in the face of rising rates, the move in rates has created the potential for higher income going forward. We recently highlighted some of the dynamics leading to increasing rates on Libor and other very short-term instruments. As the U.S. Federal Reserve (Fed) clearly has indicated its intention to continue on its path of raising the target fed funds rate, yields on other short-term instruments, including Treasury bills, commercial paper, Libor, and other instruments priced off Libor, have been increasing. For example, as seen in Chart 2, the average coupon in the FRN Index now stands at 2.60%, compared with less than 1.0% in early 2016.

 

Chart 2. Most Short-Term Rates Have Been Rising
Rates on short-term instruments, April 15, 2015–April 15, 2018

Source: Bloomberg. Commercial paper is the average yield in the 30-Day A2/P2 Non-Financial Commercial Paper Interest Rate Index. IG FRN is the average coupon in the Bloomberg Barclays Investment Grade Floating Rate Note Index. The historical data shown are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Past performance is not a reliable indicator or guarantee of future results.

 

Summary
Recent increases in short-term rates have created more attractive opportunities for income in very short-maturity instruments. Given their floating-rate nature, FRNs could continue to see increasing yields if short-term rates continue to rise. Diversified, ultra-short bond portfolios that can combine investment-grade floating-rate notes with commercial paper and other short-term securities can provide investors with a source of additional return above cash or Treasury bills, with a high degree of liquidity, limited credit risk, and limited interest-rate risk. Recent experience shows that such strategies can be a source of portfolio stability amid volatility in interest rates and equity markets. 

 

 

MARKET VIEW PDFs


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