Floating Rate Bonds:

In 2003, we searched the universe of fixed income investments for an asset class that offered competitive yields with low volatility. At the time, interest rates were at historic lows. The yield on the 10-year Treasury note was around 3.50% and the Fed Funds rate was at 1.25%. If you recall, money held in your money market and savings accounts was lucky to earn over one percent. It was a very difficult time to be a fixed income investor. We were determined, however, and our research led us to floating rate bonds.

Floating rate bonds, or bank loans, are loans made by U.S. banks and other financial institutions to large corporate customers. Typically, bank loans are the most senior source of capital in a borrower’s capital structure. They tend to have certain of the borrower’s assets and/or stock pledged as collateral. Bank loans also feature rates that reset regularly, maintaining a fixed spread over widely-accepted base rates; such as the U.S. Prime Rate or the London-Interbank Offered Rate (LIBOR).

The features mentioned in the last paragraph were what led us to invest in this asset class. First, since bank loans are typically the most senior source of capital in a borrower’s capital structure, if a company goes into bankruptcy, floating rate bond holders are first in line to get their principal returned, ahead of both other bondholders and stockholders. Secondly, the fact that most loans are backed by some specific assets of the borrower only adds to the security of these loans.

Why are these features so important? The reason is simple. Bank loans are typically rated below investment grade and can suffer during economic downturns or periods of rising defaults. Companies with strong balance sheets and AAA credit ratings like General Electric and Johnson & Johnson do not use floating rate bonds to borrow money. They instead will issue standard debt where they can pay a lower, fixed interest rate. Companies that need to delve into the bank loan market either can not raise enough backing in the open market or would have to pay too high of a fixed interest rate. Thus, it is reassuring that these bonds rank high in the pecking order in case of default and, in addition, there is a certain amount of collateral backing them.

The reset feature was also an important factor in our decision. In general, bonds perform poorly when interest rates are rising because when interest rates rise, bond prices fall. However, since floating rate bonds reset approximately every 90 days, they tend to be less vulnerable to rising interest rates.

Let’s explain how this works. As was mentioned earlier, most bank loans are pegged to a base rate such as LIBOR. LIBOR is currently around 5.35%. A company may arrange a bank loan where the interest rate it will pay is a specific percent above LIBOR. This spread will vary from company to company based on the circumstances surrounding the company (ex. balance sheet, cash flow, profitability). The average spread to LIBOR at the beginning of 2007 was approximately 2.50%.