Our first order of business is always to protect capital. (If you’re a client or a reader of this blog you likely know that’s been a constant theme in everything we do.)
In anticipation of a potential rise in interest rates, one of the risks investors should be concerned about is a decline in bond values – what many investors typically think of as “the safe stuff.” If that sounds like a dichotomy it really isn’t. Generally speaking, when interest rates go up, the value of a bond declines. The longer the maturity of the bond the more it falls. (Read our earlier posts Convexity and bonds and Is it time for bond holders to rethink their strategy?)
To protect our clients’ fixed income investments against rising interest rates — which are inevitable at some point — we’ve been shortening the duration of our bond holdings (now 3 years on average). In addition to that strategy there’s another idea we’ve implemented in recent weeks: Floating Rate Notes (FRNs).
FRNs are bonds issued by governments and corporations. They typically mature in 3-10 years from the time they are issued, but the interest rate paid on these bonds “floats” with short-term rates.
Specifically, the interest rate is reset every 90 days based on the rates banks charge their most credit-worthy corporate clients for a 90-day loan at the time of the reset.
There are two important reasons why investors may be interested in FRNs. One is that if interest rates rise the investor is protected by the fact that the interest rate is reset accordingly every 90 days.
The second reason is protection of capital. FRNs have historically not declined when rates rise because of the interest rate reset feature. That is, their relative value is protected in a rising interest rate environment.
On the flip side, FRNs wouldn’t be effective if interest rates declined meaningfully from where they are today – an event we view as unlikely.
Heather Mason-Wood, Vice President of Canso Investment Counsel, one of three independent specialty bond managers we use for client portfolios, makes the case: “At the moment, FRNs are providing almost the same yield as similar fixed rate bonds. So investors are getting the benefit of interest rate protection at no cost. We think that is a pretty good deal.”
Over the past couple of months, our bond managers have added FRNs to the mix of fixed income investments; they now represent 10-15% of our fixed income portfolios. We plan to continue to add selectively to this weighting.
The strategy is part of our ongoing effort to protect client capital, and, in concert with our asset class specialists, find the best places to put money to work productively.