Market Beat: Floating rate funds
Ben Bernanke once said, “Interest rates are used to achieve overall economic stability.”
The Fed funds rate is a tool that the Federal Reserve uses to maintain price stability and provide for full employment. They raise rates if they see signs of inflation and will lower them if the economy is slowing down too much.
Bond prices rise when interest rates are falling and fall when interest rates are rising, kind of like a teeter totter. The amount that a bond will rise or fall with a change in interest rates can be measured by using a complex mathematical formula known as the duration.
We’ve been in a bull market for bonds for over 30 years now as interest rates peaked in the early 1980s. I opened my first brokerage account in 1982 and was getting over 13 percent yield on the short-term money market fund. I also bought my first house in Truckee in the mid-1980s and my mortgage interest was about 12 percent.
Times have sure changed since then as we have seen record low interest rates and other forms of financial stimulus to help stimulate the economy. Lately, interest rates have been rising again and fixed income investors should be aware of how their bond portfolio could be impacted by rising interest rates.
The 10-year Treasury bond bottomed out below 1.5 percent and today is back above 3 percent. In a normal interest rate environment, the 10-year U.S. Treasury bond will yield about 4.5 percent to 5 percent.
Fixed-income investors can use a variety of strategies to prepare for rising interest rates. Some of these are commonly known as bullets, barbells and ladders. These strategies involve having your bond maturities at different points in time, so you can adjust to rising rates.
Another tool that can be useful in a bond portfolio during rising rates are floating rate bonds and mutual funds. TIPS are inflation protected bonds backed by the U.S. Treasury that pay a fixed rate and have an inflation adjuster based on the CPI. Floating rate bonds will adjust to rising rates typically based on the Fed funds rate. They may pay the Fed funds rate plus 1 percent. One disadvantage to floating rate investments is that investors do not know exactly what their income will be and that they will also pay less in the event interest rates are to drop again in the future if the economy slows.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.