Tuesday, April 15, 2014
Floating Rate Notes
One of the great annoyances of the current situation is that if you stay in cash or very short-term instruments, you get about as close to a 0% yield as you can imagine. If you buy bonds with maturities longer than a couple of years (that is, bonds with yields much above 0%), there is a very real danger that when interest rates start to rise, the value of those bonds will fall. They may fall quite dramatically, as everyone fights to sell their low-yield bonds. (Good time to be in cash; bad time to be in bonds.)
There is an alternative, which I need to explore: floating rate notes. I actually have some experience with floating rate notes. Some years back, I bought a bunch of Sallie Mae bonds that were floating rate. Sallie Mae is the Student Loan Marketing Corporation, one of those quasi-governmental entities. The plus side was that if interest rates rose, you were not at much risk on the capital value of the bonds, because the interest payment that you receive would rise as interest rates rose. The downside? If interest rates fell, so did the semiannual interest payments that you received -- and even more painful, the value of the bonds also fell. This was a somewhat painful experience when interest rates were even lower than today.
Still, there is some merit to looking at floating rate notes when it is hard to see how interest rates could drop much lower, but it does seem likely that one of these days, interest rates will rise again. When that happens, floating rate notes will not only give more interest, but likely hold their capital value, unless fixed rate bonds. As a strategy for improving short-term yield without putting too much capital at risk, this looks attractive. Now I just need to talk to the Bond Desk at Schwab, and see what is available, and to what rates these bonds are tied.