Floaters historically outperform their fixed-rate counterparts when interest rates rise, as witnessed in earnest over the past two months. But given the extent of the repricing that’s already occurred in fixed-coupon instruments, we believe it’s less likely that credit-related floaters will retain such a performance edge over the next 6–12 months.
The prices of floaters are better insulated from interest rate changes because the income distributions reset periodically by adding a fixed spread to the reference rate. With the exception of floaters with coupon limitation features (i.e., floors), the interest rate risk on an FRN roughly approximates the duration of the underlying reference rate. Common reference rates include the London interbank offered rate (Libor) for legacy securities and the secured overnight financing rate (SOFR) for recent issues. Since SOFR is risk-free and Libor includes a credit risk element, the majority of new senior loans tied to SOFR this year includes a credit spread adjustment, or CSA, as an additional component of the benchmark rate.
This stems from the syndicated nature of how senior loans are arranged. By contrast, more traditional IG FRNs have been issued without a credit spread adjustment.
Not only do floaters have lower interest rate duration, but they also have lower credit spread duration, meaning their prices are also less sensitive to changes in spreads. This tends to dampen their volatility in periods when either interest rates or credit spreads rise and fall, leading to less dispersion of returns versus their non-floating peers.
When considering the relative attractiveness of FRNs over 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 floaters has been striking, with the exception being in USD 25 par preferreds. Consider that year-to-date, HY bonds are down by 3.6% as of 28 February, as the 5-year Treasury rose by 46bps and heightened volatility pushed HY spreads 67bps wider. For loans, their spreads are about 30bps wider, but total return is about flat—adhering to a key theme in 2022: earning carry while protecting principal. A similar trend has occurred in IG, with IG FRNs about flat on the year while 1–5-year IG is –2.1%. How did floater performance fare when the Fed actually hiked rates last time? To answer, we look back on the late 2016 to late 2018 period that featured a series of successive hikes. Interestingly, floaters actually underperformed their fixed-rate counterparts for about 12 months before they caught up, such that similar performance was observed over the two-year period. The eventual catching-up for floaters stemmed from both higher coupon reset rates and the direction of credit spreads, which moved tighter throughout 2017 but wider in 2018. With lower spread duration, floaters outperformed in 2018 as spreads rose.
The low duration of floaters can help reduce a bond portfolio’s price sensitivity to interest rate and credit spread changes. Given the sharp move higher in interest rates, the total return performance edge for floaters has already been realized. The next phase for floaters’ value proposition will likely come from a combination of their low duration plus higher income as the Fed begins to raise rates later this month.
Senior loans have been among the most popular ways to gain floating-rate exposure within fixed income credit segments. We continue to like this asset class, but are obliged to note that the relative valuation versus HY bonds has become more balanced.
For exposure to IG FRNs, total-return-oriented investors may wish to consider ETFs that are available on the UBS platform. For buy-and-hold investors, we would be inclined to choose fixed coupon bonds with comparable five-year maturities that are issued by US banks, where yields are more attractive after the repricing in rates on this part of the curve.
Within adjustable-rate preferreds, a distinction should be made between the more volatile exchange-listed USD 25 pars and the more defensive USD 1,000 par varieties.
Main contributor: Barry McAlinden
For more, reach out to your UBS Financial Advisor for a copy of March’s Fixed Income Strategist: Revisiting credit floaters.
This content is a product of the UBS Chief Investment Office.