Understanding Floating-Rate Notes

May 2, 2013

By now every serious investor understands the consequences rising interest rates will have on bond portfolios. For more than four years we’ve been reminded that when rates go up, bond prices fall—and the longer a bond fund’s duration, the greater the losses will be.

The conventional wisdom is to keep your bond duration short if you expect rates to rise. The problem is, the iShares DEX Short Term Bond (XSB) has a yield to maturity of just 1.38% these days—once you deduct fees, that’s less than a savings account at an online bank. And unlike a savings account (which effectively has a duration of zero), short-term bonds will still lose value if rates move higher.

It should come as no surprise that the financial industry has come up with a product that tries to address this issue: it’s called the floating-rate note. A “floater” has a maturity date like a conventional bond, but its coupon is tied to a benchmark such as the Canadian Dealer Offered Rate (or CDOR, which is this country’s version of LIBOR). The coupon is adjusted every month or every quarter.

Because of this reset, floaters have a duration close to zero and won’t lose value if rates rise—indeed, they will benefit by paying higher coupons almost immediately. The iShares DEX Floating Rate Note (XFR) boasts a duration of just 0.13, yet its yield to maturity is 1.26%, just 12 basis points lower than that of XSB. Last year, as short-term rates ticked up slightly, XFR returned 1.90%, significantly more than both short-term bonds and cash.

Whatever floats your note

So what’s the catch? Why bother with short-term bonds or savings accounts when you can get higher yields and virtually no interest rate risk with floaters? As with any investment, there are always trade-offs to consider.

The first is that floaters will underperform if short-term rates decline or stay flat. While rates have been poised to rise for a long time, the fact is the CDOR has barely budged since October 2010. More important, during a period of turmoil in the equity markets, rates are likely to fall as investors rush to safety, so high-quality conventional bonds are a better diversifier in a balanced portfolio. In 2008, XSB returned over 8%, providing a soft cushion as stock markets plummeted. Floaters could not have offered that kind of protection.

The second potential pitfall with floaters is credit risk. The good news is this doesn’t seem to be an issue with XFR, which is about 85% government bonds: more than half the holdings are rated AAA, and nothing is rated lower than A. When we next experience a panic in the stock market, these high-quality bonds are not likely to see a significant decline in value.

But that’s not true of actively managed funds, which may hold floaters that are nothing more than junk bonds. The BMO Floating Rate Income Fund, for example, lost more than 48% in 2008 as high-yield bonds cratered along with stocks and real estate. The Trimark Floating Rate Income Fund also took a 28% haircut that year. Clearly these funds are not a substitute for short-term investment-grade bonds or cash.

The only other ETF in this asset class is the Horizons Active Floating Rate Bond (HFR), which falls between the two extremes. It’s exposure (through an interest rate swap) is to corporate bonds, but they’re all investment-grade, with about 70% rated A or higher. A fund with this exposure can certainly lose money during a 2008-type crisis, but it won’t suffer anything like the carnage we saw with junk bonds. I would consider this ETF an alternative to something like the Vanguard Canadian Short-Term Corporate Bond (VSC).

In my view, floating-rate notes are little more than a tactical bet on where interest rates are headed, which is inconsistent with a passive investing strategy. For long-term investors, a traditional bond allocation (whether it’s a ladder or a broad-based ETF) will provide more protection when equity markets take a tumble, and that’s the most important role of fixed income in a portfolio. And for those who need to park cash for short-term needs, a high-interest savings account is a far safer alternative.

{ 17 comments… read them below or add one }

James Elton May 2, 2013 at 9:18 am

This is something that I’ve been wondering about. Given how low rates are, is it even worth buying bond funds over some other kind of fixed income, given the severe limits on upside?

Andrew F May 2, 2013 at 9:47 am

One other dimension to consider is tax-efficiency. Because these floater funds are paying coupons in line with their yield, they can be more tax efficient to hold than premium bond funds (like XSB, XBB, etc.) in a taxable account.

I think I prefer HFR to XFR, as XFR is a bit too safe in my book. Unfortunately, the fee on HFR is a bit high too.

Jeff May 2, 2013 at 10:03 am

For a passive investor, the question ought to be: Can this asset class, as part of a diversified portfolio, increase returns for the same amount of risk or maintain the same return with a lower degree of risk over the long term?

In some ways, floating rate notes are similar to real return bonds, one is pegged to interest rates and the other is pegged to inflation (you’d think that inrest rates and inflation would be highly correlated) and yet RRBs have a place in a well diversified portfolio; not because RRBs are a good tactical bet, but because RRB’s are uncorrelated to equities and traditional bonds.

I wonder what the correlation is between floating rate notes and other asset classes such as equities, traditional bonds and real return bonds?

Canadian Couch Potato May 2, 2013 at 10:38 am

@Jeff: I understand your logic, but I expect you’d find floating-rate notes have virtually no correlation with real-return bonds. Certainly that would be the case if we’re talking about corporate notes. But even if we only looked at federal government issues, floating-rate notes have a duration close to zero and are pegged to very short-term rates, while RRBs have extremely long maturities and are more likely to be affected by long-term rates. Different parts of the yield curve do not necessarily move in tandem.

Matt May 2, 2013 at 3:10 pm

You forgot to mention BKL which is the Powershares Senior Loan ETF, which is also a floating rate ETF.

Canadian Couch Potato May 2, 2013 at 3:19 pm

@Matt: Thanks for mentioning BKL, which I had not known about. This ETF is in no way, shape or form a substitute for short-term investment grade bonds or cash. It consists of US-denominated high yield-bonds (with currency hedging added).

Joe K May 2, 2013 at 3:37 pm

So as a long term investor concerned about interest rates what bonds do you invest in?

Long term: XBB, VAB
Short Term: VSB, XSB
Corporate: VSC, ZCS, XCB
Laddered: CLF/G CBO/H
RR: ZRR, XRB
FR: XHR, HFR

Joe

KJF May 2, 2013 at 3:59 pm

I am currently using a 5-yr GIC ladder (at Achieva) ladder instead of bonds in my complete couch potato portfolio. The way I see it, it should perform slightly better than 1-5 yr gov’t bonds in stable or rising markets, significantly better if interest rates rise, but won’t get an upward bump in a 2008 type crises. It won’t lose money, either, though. Would you agree?

Canadian Couch Potato May 2, 2013 at 4:23 pm

@James Elton and Joe K: I wish there were an easy answer for you, but there isn’t: it depends on your individual circumstances. But overall, if your horizon is 10+ years, a broad-based fund like XBB or VAB should still be appropriate, as you have lots of time to adjust to changes in interest rates. I have written about this many times on the blog, for example:
http://canadiancouchpotato.com/2011/07/07/holding-your-bond-fund-for-the-duration/

@KJF: I’d agree completely. I think bond and GIC ladders are an excellent way to spread out interest rate risk (though they make rebalancing a bit difficult).

James Elton May 2, 2013 at 7:49 pm

Thanks for that, I hadn’t seen those posts. Sorry for the redundancy.

Death and Taxes May 3, 2013 at 3:02 am

Would you also consider ZAG to be a decent alternative to XBB and VAB?

Nathan May 3, 2013 at 3:44 am

@KJF: I would argue that a 1-5 year GIC ladder will perform essentially identically to a 1-5 year government bond ladder. GICs generally offer slightly better rates, but their change in value based on changes in interest rates should be effectively the same. You don’t see the change in value on your statements, but that doesn’t mean it isn’t there. For example, say you buy a 5 year GIC paying 2.5%. The next day, interest rates go up by 0.5% and there are now 5 year GICs for sale that pay 3%. Is your 2.5% GIC still worth the same amount that you paid for it?

There was an in-depth discussion of this concept in the comments of this recent CCP post: http://canadiancouchpotato.com/2013/03/06/why-gics-beat-bond-etfs-in-taxable-accounts/

Death and Taxes May 5, 2013 at 2:10 am

I forgot to add I currently own ZAG, ZXC, and CLF. I am sitting at about 35% bonds. (60% CLF 20% ZAG 20% ZXC)I am wondering which would be better for the rest if my 5% that I am going to add. XRB or XFR. I do like both but I am leaning towards XFR as I like diversity.
Thanks for this one CCP!

Pursuit May 5, 2013 at 8:35 am

And here I thought I would find clarity! But if I understand the point you made in the first paragraph, even short term laddered bond ETFs accrue less value than a “high yield” savings account but in your last paragraph you seem to recommend the opposite.

The other thing about bond ETFs that disturbs me is the ask/buy spread. By the time this is factored in, any gains I’ve made when I’ve had to liquidate seem to be wiped out.

Canadian Couch Potato May 6, 2013 at 7:56 am

@Death and Taxes: Yes, ZAG is a perfectly appropriate substitute for XBB or VAB. Regarding XRB versus XFR, the two asset classes are completely different, so your decisions would depend on what your trying to accomplish. Real-return bonds are a very long-term investment that will be harmed in the short term by rising long-term interest rates; floaters are generally shorter-term investments that will benefit from rising short-term rates.

Mark May 6, 2013 at 7:06 pm

I was wondering when we are going to get the article on Prefered’s?
Higher yield than bonds with a good income stream.
I was told it is coming?
Would love to read it.

Mark

Noel May 9, 2013 at 5:24 pm

Now what about Warren Buffett’s recent comments that ‘bonds are a “terrible” investment at the moment and that owners of long-term bonds may see big losses when interest rates eventually rise’.?

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