Rising interest rates can decimate your bond portfolio. If you're convinced that rates will rise, however, there's one kind of bond that will not only protect you against losses but also may enhance your profits.
As readers of fellow Fool S.J. Caplan's "Investor 007" bond series are well aware, more and more companies are issuing floating-rate debt instead of traditional fixed-rate bonds. With issuers such as Wachovia (NYSE: WB ) and General Mills (NYSE: GIS ) among the sellers, you should know how you can use these bonds to your advantage.
Eliminating interest-rate risk
Rising interest rates are the enemy of traditional bonds and bond funds. Although you can negate some of the impact of rising rates by holding individual bonds to maturity, you'll still suffer if you have to sell them on the open market before they mature. Most bond funds leave you fully exposed to interest-rate risk. You could even suffer a severe loss of principal if rates rise substantially, because when rates go up, traditional bonds leave you earning a lower rate than the prevailing market offers, a situation that forces your bonds to sell at a discount to their previous value.
Floating-rate bonds, on the other hand, take away the risk that fixed-income bonds bear. As their name implies, floating-rate bonds pay different rates of interest depending on prevailing rates in the bond market. The bonds generally refer to a benchmark market rate; when that rate rises, so will your interest payments. But if the rate falls, then your interest checks will go down as well.
Place your bets
When considering an investment decision, it's always helpful to put yourself in the shoes of the other party. With floating-rate bonds, for example, the question you should ask yourself is why an issuer would choose to offer bonds with a floating rate instead of a fixed rate. There are two primary reasons. Just as a homeowner may choose to take out an adjustable-rate mortgage instead of a fixed mortgage, bond issuers may be able to get financing at lower rates if they assume the risk of fluctuations in interest rates.
But if companies believe that interest rates will fall, then they'll jump at the chance to offer floating-rate debt while rates are still high. Instead of locking in high fixed rates for the lifetime of their bonds, issuers will instead reap the benefit of falling financing costs as rates decline over the years.
As a prospective buyer, you're betting against those bond issuers. If you think they're wrong and that rates will rise, then you'll make more money with floating-rate bonds. Consider, however, that while you may be investing largely on your own, companies that issue bonds get counsel from the best economists that money can buy. While that doesn't necessarily mean that they're right -- plenty of economists have been calling for rate cuts from the Fed over the past year without any success -- it should give you at least some pause before taking the other side of their bet.
Perhaps the largest downside to floating-rate bonds is the lack of certainty about the income you'll receive. Part of the value of having bonds in your portfolio is to give you a solid, dependable source of income to help smooth out the fluctuations of more volatile investments, such as stocks. Many investors, especially retirees, count on a stable source of income to cover their regular living expenses. The beauty of traditional fixed-rate bonds is that you know exactly how much money you'll get every year from your bonds.
In contrast, by their nature, floating-rate bonds prevent you from knowing for certain what you're going to get. You may find that the lower payouts you receive when rates fall come at exactly the worst time -- when you're struggling to find good reinvestment options for your traditional fixed-income securities, for example.
Yet if you've shied away from bonds entirely for fear of inflation, the falling dollar, and other factors that could push rates higher, then floating-rate bonds may be exactly what you're looking for.
How to buy them
Buying individual bonds still isn't nearly as easy as buying stocks. The easiest way to buy a diversified portfolio of floating-rate bonds is to use mutual funds. For instance, the Fidelity Floating Rate High Income Fund (FFRHX) holds floating-rate bonds from issuers such as Charter Communications (Nasdaq: CHRT ) and NRG Energy (NYSE: NRG ) . There are also a number of closed-end funds that offer floating-rate bonds, including Nuveen Floating Rate Income (NYSE: JFR ) , Franklin Floating-Rate Trust (NYSE: FFL ) , and Pimco Floating Rate Strategy (NYSE: PFN ) .
So if the prospect of higher interest rates has left you on the fixed-income sidelines, consider floating-rate bonds as an alternative to traditional bonds. Although they aren't for everyone, they can help you get the bond exposure your portfolio needs.
You can learn even more about bonds in our Bond Center.