U.S. floating-rate debt gains appeal as rate worries grow

* Investors pour more money into floating-rate bond funds

* Floating-rate debt issuance picks up to meet demand

* Some say too early to buy floating-rate debt due to Fed

NEW YORK, March 13 (Reuters) - U.S. bond investors have for years feasted on the steady gains in fixed-rate debt, but with the economy recovering and yields drifting upward, their taste is shifting to niche products like floating-rate instruments.

Interest rates on benchmark 10-year U.S. Treasuries recently touched an 11-month high. While the economic recovery appears to be progressing, it is still tentative and the Federal Reserve is expected to keep buying debt for a couple of more years.

But bond managers know the market can change quickly and yields could spike, fueling their desire for more protection.

“When things turn, they could be pretty violent,” said Chad Stephens, portfolio manager at StableRiver Capital Management in Atlanta.

Floating-rate notes protect investors from rising rates because their interest rates “reset” as market rates move higher. Most floating rate debt is from investment grade corporations or asset-backed securities backed by mortgages or receivables from credit cards or automobile and student loans.

Interest rates on such debt could rise or fall on a quarterly, semi-annual or yearly basis, depending on changes to Libor, the London benchmark.

Expectations the Federal Reserve will start to curb its debt purchases as the U.S. labor and housing markets improve have sparked a move into the sector.

Already in 2013, flows into funds that focus on floating-rate instruments have surpassed $10 billion, more than half the record inflow of $18.2 billion seen in all of 2010, according to Lipper, a unit of Thomson Reuters. Proceeds from floating-rate sales in the first two months of 2013 exceed those of the entire fourth quarter.

That is a big change from much of the previous two years, when floating-rate bonds fell from favor as the European debt crisis raged and the Federal Reserve pursued an unrelenting campaign to hold interest rates down.

Soon, Uncle Sam will jump into the game. The U.S. Treasury is expected to introduce two-year floating-rate debt by early next year in a bid to entice investors to keep buying its debt even as rates go up.

The growing appetite for these instruments has helped returns in the sector so far this year.

For instance, yields on JPMorgan’s 1.058 percent floating rate notes due May 2014 have tightened against three-month Libor. They were priced 75 basis points over Libor in May 2011, when the benchmark was 0.41 percent. On Wednesday, Libor was fixed at 0.28 percent.

Standard & Poor’s index of the top 100 leveraged bank loans, worth about $200 billion, has set a series of new highs this year, rising almost 1.5 percent after gaining 10.5 percent in 2012. Meanwhile, the Barclays index of U.S. dollar floating rate debt that matures in five years or less has risen 0.38 percent so far in 2013.

These gains on floating-rate securities, while modest, compare favorably with fixed-rate debt. The Barclays index of long-dated Treasuries that mature in 20 years or longer has fallen 5.36 percent since the start of the year, the biggest losers among U.S. bonds.

Some analysts and investors, however, say it does not pay right now to buy floating-rate bonds, which are yielding less than their fixed-rate counterparts.

They note the Fed has signaled it is committed to buying Treasuries and mortgage-backed securities at least until the end of this year, and most economists think it is unlikely to back away from its near-zero interest rate policy soon.

With a historically high U.S. unemployment rate and slow growth in Europe, inflation remains a distant threat, they say.

“It’s a timing issue for me. It’s too early to put on this trade,” said Gary Pollack, head of fixed-income trading and research at Deutsche Bank Private Wealth Management in New York.


Fixed-rate bonds have fared well so far in 2013, but a sudden jump in yields - as occurred in 1994 - would hammer pension funds and insurer portfolios, which have loaded up on fixed-rate debt in recent years.

As a precaution, some fund managers worried about a sustained sell-off in the bond market have been replacing some of their pricey fixed-rate rate debt with floating-rate.

“Some investors say certain bonds look expensive to the risk they are taking,” said Jeff Tjornehoj, head of Lipper Americas Research in Denver. “Worries about rising interest rates make a compelling case for variable-rate products.”

Joanna Bewick, who helps run Fidelity Investments’ Strategic Real Return Fund, said she has seen a “material increase” in money going to floating-rate debt funds in recent months. The fund had net investor inflows of $45.1 million in the first two months of this year, compared with $38.7 million for all of 2012, according to Lipper.

With 20 percent in floating-rate high-yield debt at the end of January, it has earned 1.2 percent since the beginning of the year.

Other floating rate funds have also seen growing investor interest. Pimco’s Senior Floating Rate Fund, launched in 2011, has attracted $167.9 million of inflows this year and now has nearly $2.2 billion of assets, Lipper data shows. It is up 1.7 percent so far this year.

For investors with higher risk tolerance, floating-rate bank loans offer higher returns than safer corporate debt.


Companies have sold $21.7 billion worth of floating-rate bonds in the first two months of the year, quadruple the amount sold in the entire last quarter of 2012, according to IFR, a Thomson Reuters unit. Recent deals include a $300 million, five-year deal for Bank of New York Mellon Corp. and a $600 million two-year note offering from John Deere & Co.

Deutsche’s Pollack said buying floating-rate debt now is not a good bet because inflation is low and the Fed is not expected to budge from its rate target for several years.

“Inflation is not a problem,” he said. “You are giving up a lot of yield in the short term.”

But some investors would prefer to be safe now rather than facing a spike in fixed-rate yields.

“We would rather be ahead of the curve than behind it,” said Richard Schlanger, portfolio manager with Pioneer Investments in Boston.