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.”