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By Shehryar Khan, CFA | 06-21-2017

Floating rate bonds in a rising rate environment

Floating rate loans may do well when rates are rising, but forecasting interest rate movements is notoriously difficult, says Morningstar Investment Management's Shehryar Khan.

Last week, Federal Reserve chair Janet Yellen announced that the central bank was following through on its move toward normalizing lending rates, hiking their overnight rate by 25 basis points. Yellen struck an optimistic tone on growth in the country, and downplayed fears of potential inflation weakness. Similarly, here at home, the Bank of Canada has started talking about the possibility of a rise in interest rates -- an encouraging sign for the Canadian economy. On the flip side, rising rates present a headwind for bonds, and investors may wonder how to position them in a portfolio.

Here at the Investment Management group at Morningstar, we are valuation-driven investors. When building our multi-asset portfolios, we aim to ignore short-term macroeconomic movements and look at any investment against the long-term return potential we expect for a given asset class based on the valuations reflected in the market.

While we can’t predict the future, the low yields in much of the developed world, even with rising rates in the U.S., means current valuations could imply lower returns going forward. In such an environment, floating rate loans could be a potentially attractive asset class, given that they have the opportunity to benefit from rising interest rates. As their name suggests, the interest payment of a floating rate loan resets at a predetermined frequency. However, we always strive to balance potential gains against the risks in an asset class. While floating rate loans may do well when rates are rising, they typically don’t do so well when rates fall, and forecasting interest rate movements with sustained accuracy is notoriously difficult. As such, any potential holding should be appropriately sized in your portfolio.

As always, investors adjusting their asset mix should keep their risk-tolerance and long-term asset allocation in mind, and revisit them regularly with their advisor if they use one. There will always be speed bumps along the way, but in the end, sticking to your plan will help get you to where you need to go.

For Morningstar Investment Management, I’m Shehryar Khan.

DISCLAIMER: ©2017 Morningstar Associates, Inc. All rights reserved. The Morningstar name and logo are registered marks of Morningstar, Inc.

Morningstar’s Investment Management group, through 11 investment advisory subsidiaries, creates custom investment solutions that combine award-winning research and global resources with proprietary Morningstar data. With approximately US$200 billion in assets under advisement and management at Dec. 31, 2016, the Morningstar Investment Management group provides comprehensive retirement, investment advisory and portfolio management services for financial institutions, plan sponsors and financial advisors around the world.

Morningstar Associates, Inc. is a wholly owned subsidiary of Morningstar Research, Inc.

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