Total Return With Floating Rate Bonds

On June 14, 2017, the US Federal Reserve raised its Fed Funds rate for the second time this year. The new range will be 1 - 1.25%. The Fed also gave a roadmap on how they plan to unwind their $4.5 trillion balance sheet.

The primary justification for the rate increase at present is not an overheating economy (as we’ve seen in the past) but the Fed’s desire to drain excess liquidity from the system after years of quantitative easing and also to return monetary policy to some sort of pre-crisis normalcy.

The goal of 2% inflation seems to be still absent from the Feds own admission and may not show up for 12 months.

The Fed is still on track for one more rate hike this year and, historically, rising interest rates tend to put downward pressure on bond prices—that is, unless you own short maturities or floating rate bonds (FRB).

Short maturities do not offer a very appealing interest coupon at the present so that leaves FRBs. Potential profit is possible by buying FRBs at a discount to their par value. Here is an example (for illustration purposes, all bonds are from fictitious companies and are investment grade in quality):

Anacot Steel has a coupon of 5% and is currently trading at Par or 1000.00 per bond. The bond will enter its floating period in three months. The bond will float and adjust quarterly at its assigned margin plus the then current three-month Libor rate. Today’s three-month Libor rate is 1.28%. The bond’s margin is 3.00%. Add the two together and the new coupon is 4.28%. Because the coupon rate has dropped from 5% to 4.28%, the bond now trades at a discount of 97 or 970.00 per bond. As the Federal Reserve continues to raise the Fed Funds rate, the potential capital gain comes into play. Theoretically, with three rate hikes of .25%, the bond’s coupon is back to 5% and the value may be back at or near Par or 1000.00 per bond. With additional rate hikes, it is possible the bond could actually trade at a premium.

The first chart below illustrates how closely the three-month Libor rate follows the Fed Funds rate.


Source: Bloomberg

The second chart (Dot Plot) illustrates the current Fed’s thinking about the future path of rate hikes.


Source: Bloomberg

For additional information on this, please contact Robert Bernard at Financial Sense Wealth Management @ 858-487-3939 or by email rob.bernard @ financialsense.com.

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