Floating rate high yield bonds could offer potential protection against inflation

Until recently, Western economies experienced historically low inflation and interest rates, with loose central bank policies, globalisation and technological innovation all playing a pivotal role in creating an unusually benign economic environment.

Today’s higher inflation may be a temporary after-effect of fiscal and monetary policy responses to COVID-19; however, it is just as likely that we are entering a new era in which some of the structural forces that suppressed global inflation after the global financial crisis of 2008 no longer apply.

For many investors, this means adapting to the potential end of a multi-decade bull run in bond markets. Fixed income securities (bonds) form a core part of many portfolios and are usually expected to provide a combination of lower price volatility than company shares (equities), and a positive real income due to their regular interest rate payments, known as coupons.

However, when interest rates are rising, but are still deeply negative after inflation, traditional bond holdings struggle to fulfil either purpose.

Searching elsewhere for inflation protection involves trade-offs. Investments that have historically beaten inflation over the long term, such as real estate and equities, can be illiquid or volatile and subject to the same discount rate-driven pricing pressures as core bond holdings over the near term.

We believe part of an investor’s strategy to navigate this new environment – or, rather, the return to normal – should therefore involve diversifying their allocation to bonds. There is no silver bullet, but in our view, high yield floating rate notes (‘HY FRNs’, or floating rate corporate bonds that are rated below investment grade) are among the potential solutions for investors taking a broader approach to inflation protection.

Income that rises or falls in line with interest rates

HY FRNs provide regular variable rate coupons, which means the income investors receive will rise or fall in line with market interest rates – usually a cash reference rate, such as SONIA, EURIBOR or SOFR[1], with the bond’s coupon typically resetting every three months. Unlike fixed rate bonds, which comprise the majority of the global government and corporate bond universe, this means HY FRN yields can rise without the bond’s price falling – in other words, they have effectively no duration risk. (Duration measures the sensitivity of a bond’s price to changes in interest rates; it essentially represents the number of years it would take for the investor to be paid the bond’s current price from all the cash flows of the bond).

[1] SONIA = Sterling Overnight Index Average, EURIBOR = Euro Interbank Offered Rate, SOFR = Secured Overnight Financing Rate.Until recently, Western economies experienced historically low inflation and interest rates, with loose central bank policies, globalisation and technological innovation all playing a pivotal role in creating an unusually benign economic environment.

Today’s higher inflation may be a temporary after-effect of fiscal and monetary policy responses to COVID-19; however, it is just as likely that we are entering a new era in which some of the structural forces that suppressed global inflation after the global financial crisis of 2008 no longer apply.

For many investors, this means adapting to the potential end of a multi-decade bull run in bond markets. Fixed income securities (bonds) form a core part of many portfolios and are usually expected to provide a combination of lower price volatility than company shares (equities), and a positive real income due to their regular interest rate payments, known as coupons.

However, when interest rates are rising, but are still deeply negative after inflation, traditional bond holdings struggle to fulfil either purpose.

Searching elsewhere for inflation protection involves trade-offs. Investments that have historically beaten inflation over the long term, such as real estate and equities, can be illiquid or volatile and subject to the same discount rate-driven pricing pressures as core bond holdings over the near term.

We believe part of an investor’s strategy to navigate this new environment – or, rather, the return to normal – should therefore involve diversifying their allocation to bonds. There is no silver bullet, but in our view, high yield floating rate notes (‘HY FRNs’, or floating rate corporate bonds that are rated below investment grade) are among the potential solutions for investors taking a broader approach to inflation protection.

Income that rises or falls in line with interest rates

HY FRNs provide regular variable rate coupons, which means the income investors receive will rise or fall in line with market interest rates – usually a cash reference rate, such as SONIA, EURIBOR or SOFR[1], with the bond’s coupon typically resetting every three months. Unlike fixed rate bonds, which comprise the majority of the global government and corporate bond universe, this means HY FRN yields can rise without the bond’s price falling – in other words, they have effectively no duration risk. (Duration measures the sensitivity of a bond’s price to changes in interest rates; it essentially represents the number of years it would take for the investor to be paid the bond’s current price from all the cash flows of the bond).

For illustrative purposes only. Assumes no change in credit spread.

Source: M&G, September 2022

Importantly, HY FRNs do not typically price in medium- or long-term interest rate expectations, given their direct link to prevailing cash rates. Whereas core (fixed rate) government and corporate bond markets have been pricing in higher future interest rates for some time, HY FRNs have not. This means, as long as interest rates are expected to rise further, HY FRN coupons should also increase, without investors needing to worry about timing the perfect entry point to obtain attractive yields.

The real level of income that investors receive from HY FRNs is further shielded by the higher yields that these bonds normally command relative to their investment grade corporate or government bond counterparts. This is because high yield bonds present additional credit risks that must be carefully identified and managed; therefore, a high yield bond’s potential return should be expected to more than compensate an investor for the extra risk taken.

A more defensive approach to high yield investing

In our view, HY FRNs provide a number of advantageous protections compared to the broader (fixed rate) global high yield bond universe. The first is that a higher proportion of the investment universe comprises senior-secured debt, which means bondholders are given priority over other debtholders if a default occurs, while specific company assets are ringfenced to help recover any potential losses.

As such, we normally prefer to invest in these securities rather than their unsecured or junior counterparts, and particularly in bonds from companies that are asset-heavy, given historically higher recovery rates.

Information is subject to change and is not a guarantee of future results.

Source: M&G, Moody’s Research, ICE Bank of America Indices, 30 September 2022. 

Downside risks can also be mitigated through active management. This may involve reducing or avoiding exposure to companies that are cyclical (their earnings go up and down as the economy expands or slows) or have less ability to pass on the costs of rising inflation to their customers, such as retailers. Conversely, more exposure can be added to companies that are less vulnerable to volatile commodity prices, such as those in the education, finance and technology, media and telecoms (TMT) sectors.

All of our investment decisions are driven by a focus on detailed, bottom-up analysis of each individual bond issuer, which is made possible by the fact that M&G has one of the largest in-house credit research teams in Europe. We believe this gives us a competitive advantage, as we do not need to rely on credit ratings provided by external rating agencies and we can determine whether a bond provides sufficient compensation for risk with a view to meeting investment objectives through the credit cycle.

Investing towards a better future

At M&G we believe the investment industry needs to evolve. Rather than short-termism and quick wins, we believe investing requires forward thinking, a long-term outlook and an active approach when searching for investment opportunities. By investing sustainably in a pragmatic and measured way, we can work towards a future that’s better for everyone, delivering positive returns for both investors and the planet.