© 2020 Arizent. All rights reserved.

What zigs when traditional bonds zag?

Register now

As advisors survey the market amid rising interest rates, variable-rate securities can provide a valuable hedge in a fixed-income strategy that can help protect clients from the rate risk associated with fixed-rate funds.

"We think these are good ways to actually take advantage of higher rates as the Fed continues to hike," says Collin Martin, director of fixed income for the Schwab Center for Financial Research in New York. "The short answer is we think they can help offset some of the risk of rising interest rates."

With interest rates that float and generally move in rough measure with the Federal Reserve rate, variable-rate funds have an obvious upside over fixed funds at a time when rates are rising.

However, those instruments can involve a trade-off of one type of risk for another.

"Floating-rate securities will play an important role in bond portfolios for investors, since they reduce interest rate risk in exchange for increased credit risk," says Samuel Miller, senior investment strategist at Signature Estate & Investment Advisors in Los Angeles.

"Looking at history, floating-rate loans outperformed traditional fixed income categories in the rising rate environments that marked 1994, 1999 and 2004-2006," he says. "These types of loans tend to 'zig' when traditional bonds 'zag,' improving portfolio diversification and smoothing out volatility in the process."

Indeed, according to Schwab, of all the indexes the firm tracks, the only two that have delivered positive overall returns this year have been investment-grade variables and bank debt variables.

"Their prices haven't suffered the same price declines that the fixed-rate market has suffered," Martin says. "So far this year their prices have held up pretty well."

At First Foundation, Rick Keller a CFP and the chairman, advocates for "an aggressive weighting to adjustable-rate bank debt as a hedge against rising interest rates."

He also notes the tradeoff of rate risk for credit quality risk and advises that "clients should always maintain a diversified portfolio in their fixed-income allocation."

Still, Keller favors variable-rate funds in the near term in anticipation of the Fed's monetary policy and the macroeconomic climate.

"As we see the economy today growing above trend for the remainder of the year and into 2019, the tradeoff of lower interest rate risk for higher credit quality risk looks like an attractive bet," he says.

Kenneth Corbin is a Financial Planning contributing writer based in Washington and Boston.

For reprint and licensing requests for this article, click here.