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Schwab Says Flight To Floating-Rate Bonds Is Premature

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.

“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.”

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