Breaking Stereotypes: Floating Rate Bonds Thrive, Even in Rate Cuts

One such example could be floating rate and senior loans.

Investors often buy these bonds to profit from rising rate environments, and then sell them once the Fed begins cutting. This trend has had the sector riding high over the last few years. However, floating rate loans tend to do well in all market cycles — even when the Fed starts cutting. With that in mind, investors may not want to cast away these bonds just yet. Strong returns could be on the horizon.

It’s important to understand exactly what a bond is. Essentially, an investor lends an entity — the government, a corporation, and individual — money. In exchange, an investor is promised to receive their principal back, either over the course of the loan or at the end, as well as interest on the loan. Most of the time, the interest rate is fixed. Meaning, the bond will pay the same amount of interest each month to the investor. It’s what gives fixed income, the “fixed” title.

But, not all bonds have a fixed interest rate.

Those bonds are called floating rate loans or notes, or floaters for short. Here, the bonds feature a coupon that will rise or fall with regards to a benchmark short-term interest rate plus a slight spread. This benchmark can include the Federal Funds Rate, Prime Rate or Secured Overnight Financing Rate (SOFR). Previously, the London Interbank Offered Rate (LIBOR) was a common benchmark for corporate floaters.

Floaters generally reset their coupon payments every 30 to 90 days to reflect the changes to their benchmarks. Because of this, in practice, floaters offer protection against a rising rate environment. So, if the Fed starts raising rates, an investor owning a floating rate bond will collect more income. Conversely, the bonds will pay less when the Fed cuts.

As a result, investors tend to buy floating rate loans once the Fed starts raising rates. This has been the trend over the last year or so. Floating rate bonds and loans have been a top performer during the Fed’s current round of hiking.

With the Federal Reserve now talking about cutting rates as early as September, many investors have begun selling or thinking about closing their positions in floaters. Afterall, lower rates equal less income for these bonds. However, they may want to ignore that conventional wisdom. It turns out, floaters may still offer plenty of value for portfolios over a full market cycle.

The key is in thinking about them not so much as bonds, but as an equity replacement.

While there are some investment-grade issuers of floating rate bonds, such as the U.S. government, most floaters are issued to borrowers with less-than-stellar credit. This is because they don’t qualify for low fixed rates. Because of this, many are considered high-yield bonds, and as a result, they provide equity-like returns. The key is that they can do so with less risk and lower volatility than owning stocks. The proof is in the data.

Investment manager Macquarie Asset Management through its Delaware funds subsidiary provides the details. Looking at the cumulative performance of floaters versus several other major asset classes, including stocks, IG corporate bonds and traditional junk bonds, floaters have managed to outperform all of them. The key to focus on is in the second half of the below chart and then follow through the Fed’s first pause in May. Floaters have continued to outperform. ¹

Source: Delaware Funds

Going forward, this trend should continue. That’s because of a variety of factors and just how floating debt works and who it is issued to.

For starters, the Fed is not going to return to the days of zero percentage interest rates anytime soon. Analysts expect a so-called neutral rate — in which the Fed doesn’t hurt or stimulate the economy — to be closer to 3.5% to 4%. That’s more in line with historic norms. Remember, while it did last a long time, the post Great Recession period and ZIRP were outliers. For floaters, this will still have them yielding equity-like returns when accounting for the embedded spread difference they offer.

Secondly, the nature of these loans and who they are issued to provide an extra boost. Because they are issued to firms with less-than-ideal credit, lower rates are a boon to their borrowing costs and their ability to repay these loans. Essentially, the credit quality of these loans strengthens when rates go down. A firm needs less cash flows to pay back its debts. That’s great news for investors, as they can now own a better-quality bond that is still high yielding.

The combination of these factors — along with the sector’s elevated current yields — according to Delaware Funds provides strong returns in rate-cutting cycles. Moreover, with the current cycle predicted to not be too severe, investors will be well-suited in these bonds over more fixed-rate junk debt.

For investors, this means they may want to reevaluate their decision to sell their floating rate and leverage loan debt as the Fed cuts and holds fast. Ultimately, they will have strong equity-like returns in the asset class without much of the volatility. Yields will remain plentiful and should help insulate against rate volatility.

Getting your hands on them has become much easier in the world of exchange-traded funds (ETFs). Like many asset classes, ETFs have opened up the world of floaters with one-ticker access. Before, it was pretty much impossible to buy them — and buying an individual bond remains incredibly hard. Often, they are bought and sold via private placements and over the OTCBB. 

This isn’t necessarily true for investment-grade floating rate loans. For example, you can easily buy U.S. Government issues directly from the Treasury. However, what Delaware Fund’s research is showing is to focus on the non-investment-grade side of the equation, and in that, funds work best.

These funds were selected based on their exposure to floating rate loans and bonds. They are sorted by their YTD total return, which ranges from 3.1% to 4.2%. They have expense ratios between 0.45% and 0.87% and have assets under management between $123M and $7.2B. They are currently yielding between 5.3% and 9.6%.

All in all, floating rate debt is still valuable after the Fed starts cutting rates, and investors shouldn’t be so quick to cast it away. The current environment is prime for these bonds to produce strong equity-like returns without the volatility. Investors shouldn’t be so quick to sell them once the Fed starts its cuts.

Floating rate bonds and loans are often sold at the first sign of a Fed rate cut. However, that may be a poor decision. Thanks to their structure and who they are issued to, floating rate debt could be a top performer once the Fed starts cutting. Investors shouldn’t be so quick to sell them from their fixed-income portfolios.

¹ Delaware Funds (June 2024). Floating-rate loans perform through market cycles