With rising interest rates across the US and Europe, 2022 has been a challenging year for fixed income investors, however, floating rate notes have proved to be relatively resilient, said James Tomlins, fund manager at M&G Investments to FSA during an interview.
The ICE Bank of America Merrill Lynch global floating rate high yield index posted a return of -6% year to date, while the ICE Bank of America Merrill Lynch global high yield index year-to-date return was -16%.
There are three reasons why Tomlins believes floating rate notes have performed better. Firstly, Tomlins points out that there is close to zero interest rate risk for investing in floating rate bonds compared with fixed rate bonds during a rising rate environment.
For fixed rate bonds, future rate expectations are priced into every cash flow across the term of the bond so if future interest rates are predicted to rise, it would move the current price lower.
“Yet in floating rate notes, the interest rate risk element is only important until the next reset date,” he said “For my portfolio, there is a reset day of every six to eight weeks, on average, so only the next month interest rate forecast is priced in today’s day’s bond price.”
Therefore, he noted that in times when bond markets are selling off because of interest rate moves, the value of floating rate notes tends to hold up better.
The second reason why he believes floating rates bonds are better in this rising rate environment is that the coupon automatically goes up when the base rate goes up.
As he believes there is no reason why central banks will reverse monetary tightening policies anytime soon, floating rate instruments will remain a very attractive instrument for another six months to a year at least.
Thirdly, Tomlins noted that in the high yield space, floating rate notes are usually senior secured notes, whereas conventional high yield bonds may not be.
“In case of a default, senior secured bondholders will get paid out first so the losses during a default cycle tend to be cushioned quite considerably.”
Yet he expects things to reverse when monetary policies start to ease, but that is likely not until the middle of next year.
“I would anticipate a fixed rate portfolio to outperform a floating rate portfolio when the broader bond markets rally because the interest rate duration element will work in investors’ favour at that point,” he added.
“In that situation, you want to invest in fixed rate portfolios and the problem is to get your timing right. If it’s too early on the pivot trade and bond markets continue to sell off, you would absolutely suffer further capital losses. That’s why the bond market has been so volatile and so costly for investors.”
Emerging markets yet to catch up
Tomlins manages the Global Floating Rate High Yield Fund at M&G Investments, which is available to sophisticated Singaporean investors.
Over the past three years, the fund posted a cumulative return of 2.90%, while the global high yield fixed income sector posted a return of -6.93%, according to FE Fundinfo.
The fund factsheet did not specify the geographical allocation of the fund, but Tomlins said the fund generally invests in Western Europe and North America..
Tomlins noted that emerging markets still have a lot to do to catch up with regards to the number of issuances.
“Corporates in emerging markets would rather tap the traditional fixed rate market because it is bigger and it is a more permanent source of funding,” Tomlins added.
“Floating rate notes are usually where banks are trying to offload liabilities and assets into the bond market and that is common in North America and Europe driven by bank regulation,”
Another reason why emerging market corporates are less inclined to issue floating rate notes is the legal process.
While the US and many developed countries have comprehensive legal systems such as Chapter 11 to protect creditors’ rights in case of bankruptcy, Tomlins noted that the legal rights for emerging market investors are less certain there.
“For instance, it is quite difficult now to enforce claims as foreign bondholders in a Chinese domestic property company. It’s quite difficult right now. Your legal rights are not certain.”
