NEW YORK (MainStreet) — Fixed income investors are desperately seeking a solution to the puzzle of currently low rates affording little income combined with the anticipation for eventual higher rates battering the value of their bonds. For the fifth month in a row, investors sold out of bond mutual funds, redeeming more than $19 billion in October, according to Lipper. That makes for a total of more than $70 billion in fixed income outflows for the year-to-date.
Looking for a rising-rate reprieve, many investors are jumping into floating rate bonds. With coupons that periodically adjust to rising short-term interest rates, "floaters" can seem seductively appealing to fixed income investors, but there are some significant risks to consider.
Kathy A. Jones and Collin Martin are fixed income experts at Schwab and have issued a new white paper regarding the risks of investing in floating-rate bonds too early.
"When used correctly, floating-rate bonds can certainly be additive to a fixed income investor's portfolio," says Jones. "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."
Jones and Martin say that while floating-rate bonds, funds and ETFs tend to perform well when short-term rates rise, many investors don't realize that income from floaters only rises when short-term interest rates increase – not when long-term rates go up alone. The analysts don't anticipate the Fed raising short-term interest rates until at least 2015, so investors might be better off buying short-term fixed-rate securities in the meantime.
"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," says Jones.
The analysts say that the longer the Fed keeps rates in check, the sharper the rise in rates will be required for investors in floating-rate bonds to make up the difference in yields. Though floaters have generated positive year-to-date returns, they are still 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," adds 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."
--Written by Hal M. Bundrick for MainStreet