Floating Rate Income Funds–Excerpt from a 2013 Vanguard report

Floating-rate bonds differ from traditional bonds in several respects that we discuss next—notably, interest rate terms, capital-structure seniority, and borrower credit quality—with each contributing to the asset class’s unique risk–return profile – From Vanguard’s A primer on floating-rate bond funds.

There has been a lot of comment recently about Floating Rate Income funds. More recently we have Tom Bradley’ Fixed Income’s New Reality (Live) discussion over the credit and liquidity risks of Floating Rate investments as well as their role in the portfolio. There has of course been a lot of press about these vehicles, and most of this coverage with few exceptions barely scratches below the surface of the issue.  

For the moment I am going to introduce excerpts from a Vanguard report (A primer on floating-rate bond funds) into these investment vehicles and in further posts discuss some of my concerns over the way they are likely being sold in the market place:

According to Morningstar, credit qualities of floating-rate funds range from BB (predominantly speculative) to B (speculative low-investment-grade), with a category average of B. For perspective, this is the same average as that of high-yield bond funds. It’s not surprising, then, that default rates of floating-rate loans have significantly outpaced those of investment-grade bonds and more closely resemble those of speculative-grade bonds

the correlation between annual changes in the option-adjusted spread (OAS) of the Barclays U.S. Corporate Bond Index—a common measurement of U.S. credit risk—and the 12-month rolling returns of the floating-rate benchmark is –0.90. This strong inverse relationship reflects the tendency of floating-rate fund returns to move in the opposite direction of credit spreads.

The industry, though, is still roughly half the size of the high-yield bond market and is vulnerable to liquidity shocks in unfavorable loan markets. For example, in 2008, when collateralized loan obligations and hedge funds—the primary investors in the floating-rate loan industry—began selling off their loans en masse, interested buyers disappeared and the market’s liquidity dried up, contributing to depressed loan prices.

An additional concern brought to light in Figure 5 is the underperformance of floating-rate bonds after the target federal funds rate ceases to rise. Significant portions, if not all, of the excess returns witnessed during recent rising-rate periods would have been relinquished (relative to various fixed income benchmarks) had investors not successfully timed their exit positions in the market

active manager selection has, at times, greatly affected floating-rate fund investors’ returns, highlighted by a median benchmark underperformance of more than 3.5 percentage points in 2009.8 Moreover, the average asset-weighted expense ratio of an open-end and ETF floating-rate fund was 0.90% as of June 2013, according to Morningstar—about 0.79 percentage point higher than the average asset-weighted expense ratio of an aggregate U.S. bond index fund.

floating-rate funds failed to consistently provide an inflation hedge from February 1992 through September 2008—a time frame that, as mentioned earlier, included three rising-federal-funds-rate periods. Since that time, high correlations between inflation and floating-rate funds can be explained by concurrent bouts of deflationary pressures and widening credit spreads through the first quarter of 2009, followed by reversions of each— and not by any inherent inflation hedge within floating-rate loans.

benchmark portfolios consisting of at least 80% bonds would have benefited (in reduced volatility) from allocating 10% to 30% of their bond holdings to floating-rate funds. However, as the figure also shows, this benefit would have quickly diminished as equities in excess of 20% were introduced into the benchmark portfolios. This reflects the well-documented diversification benefits of broad-based bond holdings for investors with balanced portfolios.

Figure 10’s data preliminarily suggest that some investors would have benefited from allocating part of their portfolio allocation to floating-rate bond funds—specifically, investors who:

• Maintain highly bond-centric portfolios (80% bond exposure or more).
• Are averse to pure interest rate risk.
• Are not averse to credit risk.

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