As investors look for yields in short-term certificates of deposit and Treasury bills, they should be aware of another fixed-income game that takes advantage of today’s higher interest rates. Enter a modest floating rate note. These instruments are fixed-income securities that pay coupon interest based on a reference rate that resets periodically. They can be issued by financial institutions, corporations, and the federal government, typically with maturities of 2 to 5 years. “Floating-rate bonds can be used to reduce the total maturity,” said Allison Bonds, head of private equity and independent wealth management at State Street’s US SPDR ETF business. of an investor’s fixed-income portfolio. Duration, measured in years, is a measure of how sensitive a bond’s price is to changes in interest rates. Bond prices move inversely with their yields, and issues with longer maturities are more likely to see prices fluctuate as interest rates change. For floating-rate bonds, the maturity is close to zero, while the fixed-rate corporate bond market has a maturity of 7 and a half years, Bonds said. The short maturities of floating-rate bonds give them a measure of relative price stability, while also providing an investor’s portfolio with some support through variable income. However, the market is a small one compared to the more well-known fixed-income categories amid rapidly rising interest rates: the iShares Floating Rate Bond ETF (FLOT) has about $7 billion in assets, in when the iShares 1-3 year treasury bond ETF (SHY) has assets worth $27 billion, according to FactSet. Flows have been more muted in 2022 and 2023, likely due to the pace of the current hiking cycle, which has been the fastest in decades, making cash itself a bit of a stretch, Bonds said. become more attractive income opportunities”. Bets on higher interest rates The Federal Reserve predicts two more rate hikes this year, according to the latest dot chart. That’s the highest number of 10 rate hikes in place since March 2022. Fed Chairman Jerome Powell recently indicated that he sees more hikes coming, he said: Inflationary pressures continue to mount and the process of getting inflation back to 2% has a long way to go.” It’s the prospect of higher interest rates over the longer term, coupled with an inverted yield curve, that makes floating-rate bonds such an attractive game for some. “This is my personal view, but I don’t see a rate cut,” said Paul Winter, certified financial planner and president of Five Seasons Financial Planning. “If we get them, I don’t think we’ll go back to zero on the federal funds rate.” For its clients, Winter has committed to allocating one-quarter to one-third of investors’ fixed income to floating-rate bonds. He prefers to use exchange-traded funds for exposure, citing greater liquidity than buying private placements. Where you keep these notes is also important: The interest they generate is taxed as ordinary income, which has a top marginal rate of 37%. These investments are better candidates for tax-deferred accounts like your personal retirement account, rather than your taxable account. Bonds show income, price stability, tame returns In a falling rate environment, floating-rate bonds can generate lower coupon payments and total returns that may be less than expected. expected if future interest rate expectations are not met, Bonds said. There are also some concerns around rollover risk: Once the Fed starts cutting rates, investors may not have an attractive source of return if they don’t lock in fixed-income assets. long-term? “Coupon interest rates are lower than the opportunity to lock in a high fixed rate right now if you consider the environment,” said Collin Martin, fixed income strategist at Charles Schwab. “Based on updated predictions that the Fed is nearing the end of its rate hike cycle, there isn’t much room for the coupons to go up.” Finally, upside opportunities are also limited — another factor for investors to consider. “If you remember Covid and the Great Recession of 2008, high-quality bonds rallied,” Winter said. “There was a flight to quality and people fled to the Treasury.” That means during a recession, you may not be able to raise the price of a floating-rate bond to make up for a drop in stocks, he said.