Schwab: Flight to Floating-Rate Bonds is Premature

Investors Still Better Off in Short-Term, Fixed-Rate Securities

November 21, 2013- SAN FRANCISCO–(BUSINESS WIRE)–A new report released today by the Schwab Center for Financial Research, a division of Charles Schwab & Co., Inc., cautions investors about the risks of investing in floating-rate bonds too early, noting that short-term, fixed-rate securities may still be the better choice in the current environment. Schwab’s fixed income experts say that by prematurely anticipating a rise in short-term interest rates, investors in floating-rate bonds may inadvertently be giving up current income in exchange for the potential for higher coupon payments down the road.

Floating-rate bonds, also referred to as “floaters,” track changes in interest rates and adjust their coupons accordingly. They tend to perform well when short-term rates rise, but what many retail investors don’t realize is that income from floaters only rises when short-term interest rates increase – not when long-term rates go up alone.

“Will Floating-Rate Bonds Sink Your Bond Portfolio?” is the latest white paper from Kathy A. Jones, vice president and fixed income strategist, and Collin Martin, senior research analyst, both fixed income experts at the Schwab Center for Financial Research. The report’s authors point out that the Federal Reserve’s eventual tapering of its bond purchases will likely have a greater impact on long-term interest rates than short-term rates. The authors do not anticipate the Fed will raise short-term interest rates until 2015 at the earliest, and argue that investors are currently better off buying short-term fixed-rate securities rather than floating-rate securities.

“When used correctly, floating-rate bonds can certainly be additive to a fixed income investor’s portfolio. But we’re finding that many well-intended investors do not have a good grasp of how floaters work in relationship to the Fed, and are inadvertently leaving money on the table as a result,” said Kathy Jones. “We want investors who might be thinking about investing in floaters to understand how they work and to take the time to calculate the income they may be giving up relative to the potential gain.”

The Case for Fixed-Rates Now

The impact of rising interest rates on an investor’s bond portfolio is important, and the authors agree that bond yields will likely continue to rise going forward. But Schwab’s experts believe the pace will be slower than many are predicting, and the magnitude of the rise may be lower than many anticipate.

The white paper explains that floating-rate bonds, which come with their own set of risks, can make sense for a fixed income portfolio when a rise in short-term interest rates is expected in reasonably short order. The authors point out that most fixed-rate bonds currently offer higher yields than comparable floaters, however – so opting for floating-rate securities may now mean that investors are giving up too much current income.

We want investors who might be thinking about investing in floaters to understand how they work and to take the time to calculate the income they may be giving up relative to the potential gain

“When we look at fixed-rate corporate bonds with short-term maturities in comparison with floaters in light of what we know from the Fed, we expect the total return from fixed-rate securities will be higher,” said Jones, noting that in its September report, the Fed indicated that 14 out of 17 members expect the first short-term interest rate increase to occur in 2015 or later.

The Schwab white paper compares investment grade and sub-investment grade short-term fixed corporate bonds alongside their floating-rate counterparts. This shows how high rates would need to rise for the yields on floating-rate bonds to break even with the yields on fixed rate securities. The longer the Fed keeps rates on hold, the sharper the rise in rates will need to be for investors in floating-rate bonds to make up the difference in yields. And although floaters have generated positive year-to-date returns, they are underperforming fixed coupon investment grade and high yield bonds.

“The data and what we’ve been hearing from investors lead us to believe that many are moving to floating-rate securities to take advantage of higher rates down the road, but haven’t figured out what they’re potentially giving up relative to the potential gain,” added Jones. “We believe most investors with an allocation to fixed income are better served right now by overweighting fixed coupon, shorter-term corporate bonds, while underweighting floating-rate bonds.”

Investors interested in learning more about fixed rate bonds versus floaters in the current environment can reach out to their Schwab financial consultant or to a Schwab bond specialist.

The full white paper, part of Schwab’s Investing Ideas series, is available here.

Schwab Investing Ideas offer analyses of key market trends and investing opportunities investors can act on now from the Schwab Center for Financial Research. More information, including other recently published insights, can be found on Schwab’s Investing Ideas page.

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