A Guide to Understanding Floating Rate Securities - Fixed Income Strategies | Raymond James
Interest rates and bond prices have an inverse relationship; so when one goes up, the other goes down. The question is: How does the prevailing market interest. Investors who believe that interest rates and/or inflation may rise and are dissatisfied with low short-term rates may consider a floating-rate investment. Since the Treasury this week auctioned floating-rate notes (FRNs) FRNs protect against inflation slightly more than fixed-rate bonds, It bears noting that the correlation of Libor with forward-looking inflation is not as strong.
Where central bankers employ a Taylor-Rule-based approach, it is plausible to argue that short rates ought to be made to track inflation fairly explicitly, and even to outperform when inflation is rising as policymakers seek to establish positive real rates.
It bears noting that the correlation of Libor with forward-looking inflation is not as strong, but these are still reasonable correlations for financial markets. The correlation between inflation and T-Bills has a much longer history, and a higher correlation 0.
Still, these are good correlations, and might lead you to argue that FRNs are likely good hedges for inflation. I simulated the performance of two year bonds: Pays an annual TIPS-style coupon of 1.
Note that both bonds have an a priori expected nominal return of 3. I took normalized inflation volatility to be 1.
For each path, I calculated the IRR of both bonds, and the results of this simulation are shown in the chart below. You can see that the simulation produced a chart that seems to suggest that the nominal internal rates of return of nominal bonds and of inflation-linked bonds like TIPS are highly correlated, with a mean of about 3.
It should also be noted that the LIBOR-based bond may be more liquid in some cases than the TIPS-style bond, and that there may be opportunities for credit alpha if the analyst can select issuers that are trading at spreads which more than compensate for expected default losses.
The analysis so far certainly appears to validate the hypothesis that LIBOR bonds are nearly-equivalent inflation hedges, and perhaps even superior in certain ways, to explicitly indexed bonds. The simulation seems to suggest that LIBOR bonds should behave quite similarly to inflation-linked bonds.
Since we know that inflation-linked bonds are good inflation hedges, it follows or does it?
Understanding Inflation | PIMCO
However, we are missing a crucial part of the story. Scott Costello There are two fundamental ways that you can profit from owning bonds: Many people who invest in bonds because they want a steady stream of income are surprised to learn that bond prices can fluctuate, just as they do with any security traded in the secondary market.
If you sell a bond before its maturity date, you may get more than its face value; you could also receive less if you must sell when bond prices are down. The closer the bond is to its maturity date, the closer to its face value the price is likely to be. Though the ups and downs of the bond market are not usually as dramatic as the movements of the stock market, they can still have a significant impact on your overall return.
Bonds, Interest Rates and the Impact of Inflation - Business in Greater Gainesville
They move in opposite directions, much like a seesaw. The opposite is true as well: When bond prices rise, yields in general fall, and vice versa. What moves the seesaw? However, other factors have an impact on all bonds. A rise in either interest rates or the inflation rate will tend to cause bond prices to drop.
Inflation and interest rates behave similarly to bond yields, moving in the opposite direction from bond prices. If inflation means higher prices, why do bond prices drop?
- A Guide to Understanding Floating-Rate Securities
- Floating rate note
- FIIG Credit Research
The answer has to do with the relative value of the interest that a specific bond pays. Rising prices over time reduce the purchasing power of each interest payment a bond makes.
Why watch the Fed? Inflation also affects interest rates. The Fed takes an active role in trying to prevent inflation from spiraling out of control. When the Fed gets concerned that the rate of inflation is rising, it may decide to raise interest rates.
To try to slow the economy by making it more expensive to borrow money. For example, when interest rates on mortgages go up, fewer people can afford to buy homes. That tends to dampen the housing market, which in turn can affect the economy.