It is a good bet to assume that in-terest rates will rise at least moderately in the next several years. A couple primary reasons for what we believe will be a gradual trend higher in rates are:
1. The Federal Reserve will start to raise tits target for the federal funds rate most likely in 2011. It may not be a dramatic series of increases, but it will be looking to remove the potential for the next speculative bubble as the economy continues to grow.
2. The large amount of government bond issuance expected in the coming years as many countries finance their growing deficits and entitlement programs will likely force market set interest rates higher.
This does not mean the rise has to be dramatic, but it will likely return rates closer to their historic norms. For example, the U.S. 10-year treasury bond presently yields just under 4 percent, but has a long-term average yield over the last 80 years of about 5.4 percent.
Of course, many investors are aware that when interest rates rise, the value of existing bonds may fall to bring their current interest payment yield in line with the higher level of rates. Over the last 30 years, as rates have fallen from the record high levels of the early 1980’s to the record low levels of the recent past, bond investors have enjoyed above average returns as bond prices rose while rates fell. We now face the specter of the opposite trend and in-vestors buying and holding bonds are likely to only profit from the interest payments on the bond, with no capital gains likely, and there is potential for temporary loss of principal value due to a rise in rates until the bond approaches maturity.
Some investors have been flocking to invest in Treasury Inflation Protected Securities (TIPS). TIPS provide an added interest payment feature if inflation rises. I believe that inflation is not necessarily go-ing to increase to high levels and the interest rate environment previously described will occur even if inflation does not move to higher than normal levels. That being said, and with TIPS at very high price levels already, we do not believe they are the best solution at present.
There is one other category of fixed income security which I think is appropriate for consideration by investors currently. These are known as floating rate bonds, or may also be called “bank loans.” Many corporations borrow money from banks to finance opera-tions and it is common for the interest payments on these loans to be tied to the prime rate or some other interest rate index.
The neat thing about bank loans is that as the prime rate rises, the borrower has to pay more in interest. Because the interest payments rise and fall with the general level of rates, the holder of the bond will see less impact on the value due to interest rate fluctuations. So, as rates rise, the income will go up and the bond's value will not fall, perhaps at all, or at least not as far as other bonds which bear fixed interest payments.
This is one category of investment where I highly recommend use of a mutual fund to obtain diversification to reduce risk and also the expertise of a manager who understands the pricing of these types of securities. Many mutual fund families offer a floating rate fund as part of their lineup.Of course, your next question should be “Tom, what can go wrong? These things sound wonderful.” Great question! Asking what can go wrong should be a higher priority than what can go right. If interest rates fall, the yield on these bonds goes down and your income level is less. I believe this is an unlikely sce-nario at present, but it is still a risk.
The second and more significant risk is issuer default. Since these bonds represent loans made to corporations by banks, a failure of the bor-rowing corporation to make the in-terest and principal payments would represent a large risk to the bond's value. When the financial crisis unfolded in 2008, the value of these securities dropped significantly as investors worried about bankruptcy and defaults. There were some defaults, but in general the drop in value of 2008 has been fully recovered.
Total loss in a default situation is unlikely because these bonds have senior standing in a bankruptcy proceeding, so recovery of 50 to 70 percent of principal value would be likely. Default risk is the primary reason I think use of a mutual fund to access this asset class is a great idea.
In summary, I think floating rate securities make some sense in the investment climate we foresee going forward, and in appropriate amounts may have a place in your portfolio.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing.