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October 01, 2011 at 08:00 PM
“Smooth out the volatility. Give up the full return potential for downside protection. Clients won’t experience the high-highs, but they won’t fall victim to the low-lows either, which is what they want, especially those heading for retirement.”
It’s about all we heard from the overlooked managers we interviewed coming out of the market lows of 2009. We thought we were through it; we were wrong, and volatility is back with a vengeance. In the month of August alone, the Dow Jones Industrial Average swung by at least 400 points on four consecutive days for the first time in its 115-year history, according to The Wall Street Journal. The reasons are obvious, but worth repeating: investor reaction to Europe’s debt crisis, economic woes in the United States and Standard & Poor’s downgrade of long-term U.S. government debt.
So a discussion of floating rate securities can’t come soon enough.
David Hillmeyer, lead portfolio manager of the Delaware Diversified Floating Rate Fund, notes the floating rate market is getting increased attention as investors seek protection from interest rate risk in today’s low rate environment—the lowest in half a century.
Hillmeyer points to two main reasons for the appeal of floating rate securities: minimal interest rate sensitivity because of their low duration and the fact that they earn increasing rates of income as interest rates rise. But, he cautions that investors need to more fully understand floating rate securities in order to select the appropriate floating rate fund.
“At this stage of the game, I would argue that floating rate products are topical for a number of different reasons,” Hillmeyer says. “We are looking at the floating rate market now not only to protect against inflation, but to take advantage of the other things driving interest rate volatility, whether it be sovereign debt issues around our fiscal situation or what’s going on in Washington and Europe. We constantly ask ourselves what this means for financing costs for countries around the globe.”
He adds that if you layer in the fact that 35% of the overall global GDP comes from developing economies, investors have to consider the resulting increase in demand for commodities and, by extension, it’s effect on pricing.
“If you would have asked me five years ago about how I would approach the floating rate market, I would have told you, ‘Well, you approach it from the standpoint of being very tactical,’” he says. “When you think rates are going higher, you invest in the asset class, and when you think rates are going lower, you pull back and go into fixed rate securities. I think it’s an interesting way of looking at it from a strategic standpoint, just given all the uncertainties and the unknowns that are out there.”
Hillmeyer emphasizes that the manner and amount of floating rate securities in the overall portfolio are specific to the individual, but with the disclaimer out of the way, he says, generally, 5% to 15% is an appropriate target.
“It’s important to position that portion of the portfolio in a way that you don’t have a tremendous amount of commitment around the direction of rates, whether they go higher or lower,” he says. “Investment professionals could put pretty compelling arguments out there for both scenarios. But you allocate a percentage to your portfolio as a hedge. And you look at it in the context of what your needs are for fixed income and how much of your portfolio is, in fact, in fixed income that you need to protect. I would not switch all my holdings from fixed income into floating rate products; that’s too bullish of a call on floating rates. But I do think it plays a very important role in the allocation process.”
