June 8, 2010
3. Floating Rate Bank Loans: Short duration and adjustable yield
With high-yield bond spreads back within their historical range, we have seized the opportunity to realize some of the gains we experienced and directed them to something better positioned for rising rates. While high-yield bonds still provide a healthy yield that should help offset their falling prices in the wake of a rate increase, the time for easy money from this asset category has passed.
Most floating rate bond funds use senior bank loans that have been securitized and are similar in credit quality to those of high-yield bonds. Bank loans are higher in the capital structure than high yield bonds, so in the event of a default, bank loan holders typically get paid back first. A major difference between floating rate funds and typical high-yield funds is that floating rate loan yields will adjust with changes in LIBOR. With the recent doubling of LIBOR, the yield you receive from these funds goes up. These funds are also typically very short in duration so your principal has less interest rate exposure.
Floating Rate strategy considerations
Last year, we introduced both high-yield and floating rate bonds into our models. This year, we favor floating rate over high-yield exposure for new allocations and are systematically reducing our high-yield exposure. We currently use Fidelity Floating Rate High Income Fund (FFRHX) with a 30-day SEC yield of 3.45 percent and a weighted average maturity of 3.96 years (source: Morningstar, Inc. as of 4/30/2010). This fund exhibited lower volatility when compared with most peers over the past several years, and we feel that a more conservative, consistent investment approach is preferrable with lower-quality rated securities.
4. TIPS: Good for inflation and inflation expectations
As the only strategy with a direct tie to the Consumer Price Index (CPI), Treasury Inflation-Protected Securities (TIPS) are a natural place to invest if you are concerned about inflation. As the CPI rises, the principal on TIPS adjusts upward. In return for this feature, investors give up some yield. With current inflation all but non-existent, the CPI contribution is minimal.
TIPS prices respond more to inflation expectations than to actual inflation. For example, when inflation expectations were low in 2008, TIPS went lower. When expectations about inflation increased as the economy and stock market started to recover, TIPS also increased in value. Actual inflation during this entire time period was very tame and relatively constant.
Currently, we don't advise overweighting TIPS or using TIPS as your sole inflation-fighting strategy for two reasons. First, TIPS' investors bid up their prices late last year when concerns related to future inflation began to circulate. Second, you could suffer a holding-period total-return loss even if you correctly timed your purchase. A total return loss is possible when rising interest rates decrease your principal and the low real yield and inflation adjustments are not sufficient to offset the price decline.
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