A life preserver for rising interest rates

In operation, floaters pay a variable premium over a base rate set on the Canadian dealer offered rate (CDOR); the CDOR is the average of dealers’ bankers’ acceptance bids. (The U.S. London interbank offered rate [LIBOR] is similar.) In each case, the premium turns the longer-dated five-year note into the equivalent of notes with a maturity of one year or less that reflect the going rate for short loans to senior borrowers.

“Floaters now are the sweethearts of the bond market because they capture rising interest rates without any inflation expectations,” says Beste Alpargun, portfolio manager with Seamark Asset Management Inc. in Halifax.

Floater resets track interest rate moves, and anticipation of rate resets can move floater prices upward. Both are things that fixed-rate short-dated bonds cannot do.

“You can think of floaters as five-year notes with almost no duration risk,” says Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Inc. in Toronto. “You still have credit risk, as all floaters are either provincial [bonds] or are issued by financial [services] institutions or other corporations.”

Not all bonds with adjustable payouts are working in the present climate of rising interest rates and low inflation, though. Real-return bonds (RRBs), which pay a base interest rate plus a bonus that tracks increases in the consumer price index, are not offering much protection at all. Given that all RRBs are long-dated issues with maturities of as much as 30 years, RRBs have high sensitivity to rising interest rates.

Moreover, because RRBs set their payment in relation to inflation, which is currently weak, these bonds have failed to keep pace with interest rates that are rising in anticipation of the end to central banks’ bond buying, particularly in the U.S. The combination of rising interest rates and moderate inflation is unusual, yet floaters, unlike RRBs, work well in this odd environment.

Consider the recent history of floaters: for the 12 months ended Aug, 31, RRBs lost 10%. That’s even worse than the record for all long-term bonds, which dropped by 6.48% in the same period. However, short-term bonds gained by 0.32% for the same period – essentially, their coupons minus modest price erosion. Best of all, one-year floaters thrived.

For example, a Canadian Imperial Bank of Commerce floating-rate issue due July 11, 2014, was recently priced at CDOR plus 64 basis points. This bond has appreciated to $100.47, so the yield to maturity has dropped to 1.29%. The nominal annualized appreciation works out to 2.8%, which is exceptional for a three-month fixed-income instrument. It’s no wonder, then, that floaters are in the limelight now.

The problem with buying floaters is their scarcity. About 100 floaters trade in Canada, giving them rarity value. That price support, plus the ability to gain value with anticipated rises in interest rates, says Stéphane Ruah, director of wealth management with Richardson GMP Ltd. in Montreal, sets up floaters for price gains.

For advisors who don’t want to shop the bond market directly, there are several floater-based exchange-traded funds (ETFs), including iShares DEX Floating Rate Note Index Fund. Among the U.S. floater ETFs, there’s SPDR Barclays Investment Grade Floating Rate ETF. Each gives diversification with low management expense ratios.

But there’s also floaters’ checkered history to consider. From 2007 to 2011, as interest rates were falling, Ruah explains, floaters did poorly. There was not much demand for floaters because the prospect was that the notes would pay just the coupons, which were being reset downward, minus the variable adjustment that anticipated the lower resets. In contrast, the downward trend of interest rates made long bonds much more attractive.

The current popularity of floaters has to be compared to simple alternatives such as using bank guaranteed investment certificates. At the time of writing, 90-day term deposits were paying as much as 1.35%. The slightly reduced yield to maturity of the floater reflects the ability of the holder to cash in at any time. The reduced yield amounts to a liquidity discount and a price premium on interest rate adjustability.

Floaters, as noted earlier, track bankers’ acceptances closely, as both of these fixed-income instruments are set on the CDOR. The difference is that floaters can gain from spread tightening (that is, a rising price) compared with federal short bonds if investors see improvements in issuers’ balance sheets. In such cases, floaters’ prices can rise and produce capital gains, says Chris Kresic, partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto, who adds that many floaters have been issued by provinces: “If they get their budgets in order or banks or occasional industrial issuers such as Bombardier Inc. improve their balance sheets or credit ratings, their floaters’ prices will rise.”

Of course, the credit quality of a floating-rate bond issue can decline, thus widening the price spread compared with the reference standard of federal bonds.

“[Floaters] are not a one-way street and can just as readily generate price losses if spreads open up,” says James Hymas, president of Hymas Investment Management Inc., a Toronto-based firm that specializes in fixed-income investing. “The spreads can open up for the specific issue, for any category of issuer that ranks below the Government of Canada or because an issuer has subordinated the floater [or, indeed, any other bond] by issuing more debt or more senior debt.”

One very important point to note is that even though floaters usually are short-term notes, they have been issued as long-dated obligations in the past. Says Hymas: “Where an investor holds a long-dated floater, there’s more time for credit-quality issues to arise. In that case, rate resets will matter less than quality deterioration and potential decline in liquidity if holders rush to sell and overwhelm buyers. This is all potential, but it did happen in 2008.”

Yet, as Marc Stern, vice president and head of discretionary wealth management with Industrial Alliance Securities Inc. in Montreal, explains: “Floaters provide yield, protection from price declines and can, and indeed have, produced capital gains.”

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