After falling for more than three decades, interest rates have nowhere to go but up. Higher interest rates aren’t necessarily a bad thing. After all, the U.S. Federal Reserve recently hiked rates because the economy looked relatively healthy and unemployment is low. In this case, rising rates are sign of economic strength.
Investors may not appreciate the impact of higher interest rates on their bond portfolios, however. That is because bond prices and yields move in opposite directions. So when yields climb, bonds generally fall in value. If rates rise by a percentage point, a bond yielding 5% is worth less in a world where similar bonds now yield 6%.
Bond investors can shield their portfolios against the impact of higher rates with a floating rate bond fund. As the name indicates, these funds hold bonds whose yields rise and fall with interest rates. While floating rate funds have limited interest-rate risk, they usually carry plenty of credit risk. Most floating-rate funds hold loans extended to lower-quality borrowers. These borrowers are often distressed, operate in cyclical industries, or have been the target of leveraged buyouts. Such loans, often called bank loans, are typically rated below investment grade. Bank loans tend to suffer in rough markets as a result. During the financial crisis of 2008, the Credit Suisse Leveraged Loan Index, which tracks bank loans, fell 10.8% in Canadian dollar terms.
While ETFs like PowerShares Senior Loan provide relatively inexpensive exposure to floating-rate debt, we’d opt for active management in this asset class. Bank loans are customized to each borrower, and it takes expertise and deep resources to dig through the terms of the loan and assess the value of the collateral backing it. With highly experienced management and large team of seasoned analysts, our favourite choice in the floating rate category, Bronze-rated Renaissance Floating Rate Income, fits the bill. The fund’s subadvisor, Ares Management, has managed risk well with a versatile, value oriented strategy.
Floating rate funds complement core bond holdings well and they’ve been effective diversifiers to Canadian investors’ domestic equity holdings. Given their risks, floating rate funds should play a niche role in a diversified fixed income portfolio.
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