Thomas Rentsch
CFA, Senior High-Yield Portfolio Manager
Risk premiums on corporate bonds are low, and the hoped-for interest rate cuts may not materialize!
This raises the question: Where should you invest your money? We’ll show you a niche segment where you can still achieve high-single-digit returns on corporate bonds.
Background
The decline in inflation has slowed globally in recent months, dampening hopes for significant interest rate cuts in 2024. At the same time, risk premiums on corporate bonds have narrowed further, making it more difficult to find promising or high-yielding investments.
Opportunity
One bond segment that still promises very attractive returns is so-called floating-rate notes (FRNs). With these, the coupon is variable and consists of a premium over Euribor¹. They typically have a high-yield rating and benefit from the currently high interest rates in the short-term maturity segment. As a result, FRNs still offer coupons and yields ranging from 8% to 9%.
Source: Bloomberg, equally weighted portfolio of all 103 floating-rate notes (in euros, minimum volume of €200 million, lowest rating of BB- or lower but at least B-, no financial institutions), as of March 19, 2024.
Limitations
However, when investing in FRNs, one must also accept certain limitations.
For example, these instruments generally offer only very limited protection against early redemption, which can reduce the yield and severely limit potential price increases if risk premiums continue to fall.
At the same time, due to their variable interest rates, they do not benefit from falling interest rates—on the contrary, this would actually lead to a decrease in the coupon!
Furthermore, the selection and liquidity in the secondary market for FRNs are significantly lower than for fixed-rate bonds.
In addition, most FRNs are B-rated bonds, meaning they tend to have weaker credit profiles. This makes fundamental analysis of the issuers and active management by experienced credit experts, such as those at H&A Global Investment Management, indispensable when investing in FRNs.
Conclusion
With FRNs, investors trade potential price appreciation for high current coupons should risk premiums and interest rates continue to fall. This appears to be a good compromise in the current environment of inflation that is proving more persistent than expected and risk premiums that have already fallen significantly.
In particular, when used as a replacement for or alternative to short-term fixed-rate bonds, FRNs can leverage their advantage of high coupons, since, due to their low duration, significant price gains from falling interest rates or risk premiums cannot be expected with these bonds anyway.
In our view, FRNs therefore represent an attractive addition to actively managed high-yield portfolios for income-oriented investors in the current environment.
¹ Euribor = Euro Interbank Offered Rate = reference interest rate for unsecured term deposits in euros in the interbank market.
Risks
Past performance is not indicative of future results, nor can future performance be guaranteed.
Disclaimer
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