Floats historically outperform their fixed rate counterparts when interest rates rise, as evidenced by the past two months. But given the extent of the repricing that has already occurred in fixed coupon instruments, we believe it is less likely that credit-linked floats will retain such a performance advantage over the next 6-12 month.
Benefits for investors
Float prices are better protected from changes in interest rates because income distributions reset periodically by adding a fixed spread to the benchmark rate. With the exception of floats with coupon limiting features (i.e. floors), the interest rate risk on an FRN approximates the duration of the underlying benchmark rate. Common benchmark rates include the London Interbank Offered Rate (Libor) for older securities and the Guaranteed Overnight Funding Rate (SOFR) for recent issues. Because SOFR is risk-free and Libor includes an element of credit risk, the majority of new SOFR-linked senior loans this year include a credit spread adjustment, or CSA, as an additional component of the rate of credit. reference.
This stems from the syndicated nature of how Senior Loans are arranged. In contrast, more traditional IG FRNs were issued without adjusting credit spreads.
Performance
Not only do floats have a shorter interest rate duration, but they also have a lower credit spread duration, which means their prices are also less sensitive to changes in spreads. This tends to dampen their volatility during periods when interest rates or credit spreads rise and fall, resulting in less dispersion of returns compared to their non-floating counterparts.
When considering the relative attractiveness of FRNs versus fixed rate securities, the starting point matters. At no time has this been more relevant than in today’s market where the relative outperformance of floats has been striking, with the exception of $25 preferred stocks. Consider that year-to-date, HY bonds are down 3.6% as of Feb 28, while 5-year Treasuries are up 46bp and increased volatility has widened HY spreads by 67 bp. For loans, their spreads are around 30 basis points wider, but total return is roughly flat, in line with a key theme in 2022: earning carry while protecting principal. A similar trend occurred in the IG, with FRN IG roughly flat over the year while the 1-5 year IG is -2.1%. How did the float’s performance fare when the Fed actually raised rates the last time? To answer, let’s go back to the period from the end of 2016 to the end of 2018 marked by a series of successive increases. Interestingly, floats actually underperformed their fixed-rate counterparts for about 12 months before catching up, so a similar performance was seen over the two-year period. The eventual catch-up in floats stemmed from both higher coupon reset rates and the direction of credit spreads, which tightened through 2017 but widened in 2018. With a shorter spread duration , floats outperformed in 2018 as spreads widened.
Take away food
The low duration of free floats can help reduce the price sensitivity of a bond portfolio to changes in interest rates and credit spreads. Given the sharp rise in interest rates, the total return benefit for floats has already been realized. The next phase of the floats’ value proposition will likely come from a combination of their lower duration and higher earnings as the Fed begins raising rates later this month.
Senior Loans have been among the most popular means of gaining floating rate exposure in fixed income credit segments. We continue to appreciate this asset class, but it is clear that the relative valuation against HY bonds has rebalanced.
For exposure to IG FRNs, total return-focused investors can consider the ETFs available on the UBS platform. For buy-and-hold investors, we would be inclined to choose fixed coupon bonds with a maturity comparable to 5 years issued by American banks, whose yields are more attractive after the revaluation of rates on this part of the curve.
Within the adjustable-rate preferred shares, a distinction should be made between the more volatile USD 25 shares listed on the stock exchange and the more defensive USD 1,000 shares.
Main Contributor: Barry McAlinden
For more information, contact your UBS financial advisor for a copy of Fixed Income Strategist: Revisiting credit floaters.
This content is a product of the Chief Investment Office of UBS.
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