- A few weeks ago, in my blog FixedIncomeNow, I made a post about how I expected current record low rates of interest to increase at some point in the near future. After all, the US economy is ameliorating at a steady peace and unemployment is starting to react to this growth. When rates go up, bond prices go down unless your bonds have a floating coupon. Since 2008 bonds with floating coupons – usually tied to the London Inter Bank Offer Rate (LIBOR) – have been the big losers of the fixed income world. Of course, as the FED funds rates went down from over 5% in 2007 to nearly 0% in 2009 (staying there until now), bonds with fixed coupons were the big winners and soared in price. Right now it might be the time to start moving out from fixed coupon instruments to floating ones. Instruments that reflect the price and performance of investment grade fixed coupon bonds will be the riskier assets.
Even if it sounds counter intuitive, a very well constructed fund like the iShares Investment Grade Corporate Bond ETF (NYSEMKT: LQD) will be a dangerous place to stay invested in. With a weighted average coupon of 5% and a weighted average maturity of 11.86 years, the current weighted average Yield To Maturity (YTM) is just 3%. As soon as rates start to go up, this ETF (and all its equivalents) will plunge accordingly. As simple as that. Even one of my favorite fixed income instruments, the iShares High Yield Corporate Bond ETF (NYSEMKT: HYG) shall be a very dangerous instrument to own. As a matter of fact, and even if it sounds very counter intuitive, this last ETF is going to be safer than its investment grade equivalent. The reason is simple, an improving economy will make the average rate of insolvency of US companies lower (making high yield bonds safer) and, at the same time, the weighted average maturity of the high yield instrument is significantly shorter at 4.3 years. Besides, the current weighted average price premium on the high yield ETF is not higher than that at its investment grade equivalent (the iShares High Yield Corporate Bond ETF has a weighted average coupon of 7.53% and a weighted average YTM of 5%). A good measure of yield to price risk is the bond’s duration. The higher the duration, the harder the bond’s price falls for every extra point in the bond’s YTM. Actually, the iShares Investment Grade Corporate Bond ETF’s weighted average duration is 7.69 years while the iShares High Yield Corporate Bond ETF’s effective duration is 3.91 years. The shorted the duration, the more protected you are as rates go up.
Fixed Income Safe Heavens.
As I mentioned at the beggining of the article, you should go for floating rates. iShares has a fairly good ETF that owns bonds whose coupon payments change based on prevailing short term interest rates. This fund, called the iShares Floating Rate Note ETF (NYSEMKT: FLOT), which has a very low weighted average coupon of 0.91% and a weighted average YTM of 0.61%, should outperform the market when rates go up but is not my favorite instrument to play the coming trend. After looking at many instruments, I could find one that I am seriously considering to buy: the Goldman Sachs Preferred Shares A Series (NYSE: GS-A). This shares will yield you 3 Month LIBOR + 75bp with 3.75% Dividend Floor. Trading at 91% of face value the current cash yield is around 4.3%. They pay 10th day of February, May, August, and November and they are perpetual shares. If you are looking for a floating rate instrument go long Goldman Sachs Preferred Shares A Series!