Question:
I am getting close to retirement and looking for an investment that is secure, while getting a better return than a CD. I have plenty of exposure to the stock market. I have recently heard of floating-rate bond funds. What is your opinion?
Answer:
Typically, our philosophy is to invest in investment-grade bonds rated AA or higher, especially for a retiree. We generally purchase bonds to cover a liquidity need 10 years away. If 10-year interest rates are undesirable, we will look to a short-term CD until interest rates rise.
Floating-rate bonds typically include junk bonds rated BB or lower and bank loans that adjust with interest rates. It is important to understand the basics of floating-rate loans, which are variable-rate loans made by financial institutions to companies that are generally considered to have low credit quality. In addition, a floating-rate bond fund’s expense ratio is usually higher than an average of 1.3% as reported by Morningstar, compared with 0.90% expense ratio for investment-grade funds.
In good times and in bad, the floating-rate funds have been cyclical with high betas in the most recent recessions. We feel this defeats your desire for security. While the aforementioned bank loans are senior and secured in a sense and may have a higher recovery rate in default than junk bonds, we feel they are not a way to protect principal.
Floating-rate bond funds also have very high volatility. In 2008, during the market crash, floating-rate bond funds underperformed the benchmark by 35%. However in 2009, they overperformed the benchmark by 36%. For money that you need for retirement, we feel this is hardly a secure investment.
There is a perception that bonds are safer when interest rates are higher; however, when interest rates are higher, lower quality companies struggle more. Large stable companies can currently borrow at historically low rates, so they do not need to offer investors floating-rate bonds to raise capital. Further, most market participants believe interest rates are likely to rise in the near term, making it unwise to issue debt with potentially rising rates. While junk bonds are still an IOU from a corporation, these are the bonds that pay high yields to bondholders because the borrowers don’t have any other option. When a corporation’s credit ratings are less than pristine, it is difficult for them to acquire capital at average market rates.
For the conservative investor, we recommend long-term principal protection with safe income and limited volatility in the form of investment-grade bonds rated AA or higher. Note, we recommend bonds and not bond funds, as bond funds do not have a maturity date, and thus all act in many ways like floating-rate funds.