What weighting between fixed and floating rate securities should be used in fixed-income portfolios? Diversifying between fixed- and floating-rate securities can be beneficial in today's financial and geopolitical conditions as the economic backdrop and interest rate environment change.
Allocating to floating-rate loans can be an excellent way to diversify fixed-income exposure. Floating-rate loans reduce interest rate risk while generating high levels of income, acting as a hedge against fixed coupon bonds. Their coupons have two components - a fixed spread and a floating rate reference rate, which is closely tied to the Fed Funds rate.
This combination helps stabilize portfolio performance across different interest-rate environments and complements the steady income provided by fixed-rate bonds. Floating-rate securities can offer greater income, especially in inflationary or rising interest-rate environments.
Historically, when the Fed is hiking interest rates, floating rate loan coupons increase, and at the same time, medium- and longer-duration bonds can decline if Treasury yields are also increasing. On the other hand, when the Fed has cut rates, medium- and longer-duration bonds have outperformed floating-rate loans. With current expectations of “higher interest rates for longer,” there is a case to be made for investing in floating-rate loans.
President Trump's return to office introduces new uncertainties, particularly around trade policy and fiscal initiatives. His stated intent to continue the 2017 tax cuts and introduce sweeping policy reforms could impact market sentiment and inflation.
Enormous fiscal spending by the US and other countries makes it likely that government spending will continue to prop up economies. Growth may slow in 2025, but inflation may prove to be sticky. If there are no additional cuts in the Fed funds rate, we could see a rise in interest rates along most of the yield curve in 2025. Increased overall bond issuance could also lead to investors demanding higher yields to invest, theoretically forcing the yields on other investments up. These factors would benefit floating-rate debt.
A balanced approach, such as allocating 70% to traditional fixed-rate bonds and 30% to floating-rate securities, has historically provided better returns with less risk than a standalone allocation to traditional bond funds. Floating-rate loans should be considered a strategic allocation rather than a tactical one, and a consistent allocation to floating-rate securities should be maintained throughout market cycles rather than trying to time entry and exit points.
While floating-rate securities can provide benefits, they also carry credit risk and income uncertainty. Investors should balance these factors against the stability offered by fixed-rate bonds. Floating-rate loans are typically extended to companies with higher levels of debt, offering exposure to a different segment of the credit market compared to traditional fixed-rate bonds. In the event of an economic downturn, the below-investment-grade nature of these loans can make them more vulnerable to increased default rates.
Floating-rate loans have historically displayed low correlation with traditional asset classes, helping to reduce overall portfolio volatility. They have even shown negative correlation with investment-grade bonds, which can provide valuable diversification. In a rising interest rate environment, floating-rate securities can act as a hedge against fixed-rate bonds while offering portfolio diversification and potentially greater income. This diversification can lead to a smoother investment experience with steadier performance over time.
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David Rosenstrock, CFP®, MBA, is the Director and Founder of Wharton Wealth Planning (https://whartonwealthplanning.com/). He earned his MBA from the Wharton Business School and B.S. in economics from Cornell University. He is also a CERTIFIED FINANCIAL PLANNER™.