Riding the interest rate wave with high-yield floaters

We are still in the early stages of rate hike cycles, argues M&G Investments. (Image: Shutterstock.com/Thapana Studio)

High-yield floating rate notes (HY FRNs) have significantly outperformed fixed-rate securities during the period of monetary tightening. Credit spreads are above their long-term average, and downside scenarios are already priced in. M&G Investments derives attractive opportunities from this.

HY FRNs stand for High Yield Floating Rate Notes, i.e. bonds with floating interest rates. They allow investors to benefit from rising interest rates because, as the name suggests, the coupon is adjusted to the interest rate level. In contrast, fixed-rate bonds lose value when interest rates rise; with the fixed coupon, investors trade themselves a malus when interest rates rise.

The specialists at M&G Investments continue to view the environment for high-yield floating-rate bonds as favorable. "We are still at the beginning of the cycle of rate hikes, and future hikes are not yet reflected in HY FRN coupons", writes the British financial house in an analysis.

Three important characteristics

Three features suggested the asset class should continue to provide potentially attractive diversification for fixed income investors in the period ahead.

First, the low interest rate risk: HY FRN have almost no duration. So, all things being equal, interest rate increases should not result in capital losses for bondholders. This, he said, could make HY FRN attractive to investors who fear further selling pressure on fixed income in the event of future central bank rate hikes. "For these investors, HY FRNs could potentially be more attractive than the broader global high-yield bond market", says the analysis.

Before further increases in interest rates

Secondly, the variable interest rate: The coupons are usually adjusted every three months to the interest rates on the money market: "We are still in the initial phase of the interest rate increase cycles", M&G argues: US Fed funds are at 1.50% to 1.75%, the ECB deposit rate is -0.5%. Thus, expected rate hikes are not yet priced into the coupons of high-yield floaters. Against this backdrop, higher interest rates should benefit HY FRN investors – because the return potential is higher. "Their high-yield coupons can potentially offset inflation effects much better than their investment-grade counterparts", reads the statement.

Third, increased credit spreads: As shown in the chart below, the spreads are currently larger than the long-term average of 484 basis points (bps). According to M&G, high-yield bond spreads may be approaching their highest level within the entire cycle. "A lot of bad news is already priced into this". HY FRNs are typically senior secured, which provides additional protection.

HY FRN spreads above the long-term average of 484 bp

"Our view is that companies are entering the economic slowdown from a healthy position. Net debt and the level at which interest due has been serviced have been high recently. That's why we expect that defaults in the event of a recession will likely be lower than in previous recessionary periods", the finance house added.

Braced for multiple scenarios

At current spreads, they are convinced that floating-rate high-yield bonds offer a potentially attractive remuneration in relation to credit risk. M&G's baseline scenario for the next few months calls for unchanged or slightly tighter spreads.

"Our portfolio continues to be positioned to handle a range of possible scenarios with changing interest rates and spreads", explains James Tomlins, manager of the M&G (Lux) Global Floating Rate High Yield Fund. And should the market stabilize while interest rates rise? Tomlins' response: "This would likely result in mid to high single digit returns for the asset class."

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