I have often pointed out that the net asset value of bond investments fall when interest rates increase. If you purchased a bond with a coupon rate of 5 percent, with a face value of $1,000, and interest rates increase to 6 percent for a similar maturity, no one will be willing to purchase your bond at $1,000 if a new bond is issued paying 6 percent.
The value of your bond will fall in value, so that new investors would receive the same yield to maturity as the bond with the coupon rate of 6 percent.
Investors who don’t expect to hold bonds for a long time should avoid purchasing any long-term bonds or bond funds since their value will fall more than bonds with shorter maturities.
If you expect to hold your bonds/bond funds on a long-term basis, and you are investing your interest in new bond investments, then don’t be concerned about short-term increases in interest rates. That is because you are making new investments in bonds with higher returns. In the long-run, your returns will increase because of the higher returns from your new investments.
If you are a short-term investor, however, then one way to avoid the risk associated with higher interest rates is to sell your long-term bonds or bond funds and invest in floating-rate bank loans or bank loan funds.
When you invest in these loans, when interest rates increase your investments are immediately invested in new bank loans at the higher interest rates. Your investment will not fall in value because of the higher interest rates.
However, these loans are not risk free because of the potential risk of default by the bank. You have to make a distinction between “interest rate risk” and “creditor risk.”
When you purchase a 30-year Treasury bond or bond fund, you are not concerned about creditor risk, because you know the U.S.Treasury will continue to pay interest on time and will repay your investment in full at maturity.
Nevertheless, you are susceptible interest rate risk, because if you sell your investment prior to maturity in a time of rising interest rates you are subject to capital loss.
Conversely, when you purchase a floating-rate loan or loan fund, you avoid interest rate risk but are subject to creditor risk, because no bank can guarantee it will always be in business and able to pay interest and principal back in full.
In a recent article of Barron’s, Lewis Braham indicated that American Beacon Sound Point Floating Rate Income Fund (SPFLX), was the best performing floating-rate mutual fund in the past five years. According to Morningstar, the return on this fund has been 5.7 percent annually in comparison to its peer’s return on average of 3.3 percent.
There is a new retail share class (SPFPX) (same portfolio) which has a $2,500 minimum investment. The annual expense ratio is 1.11 percent, which is relatively high. The fund managers use 11 loan analysts and concentrate on risk control.
In the past year, the gain of SPFPX was 4.5 percent. The return for the last year for many conservative, diversified bond funds and ETFs were negative. That is because the Fed increased short-term rates many times. It is likely, in the short run, the Fed will continue to raise interest rates.
Accordingly, if you are a short-term bond investor, you may want to consider part of your bond investments in floating-rate bonds. You can ask your financial adviser or broker for individual recommendations. In order to minimize your risk, consider only a mutual fund or ETF rather than an investment in one bank.
As long as the Fed is continuing a policy of increasing interest rates, it is likely that floating-rate funds will outperform traditional, conservative bond funds on a short-term basis.
This article provided by NewsEdge.