Mark Shohet, Portfolio Manager on the BlueBay U.S. Fixed Income team, discusses how floating rate assets still have a part to play in your asset allocation.
Watch time: 3 minutes, 54 seconds
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Rend speaker: Mark Shohet
Hello & welcome back to The Weekly Fix. My name is Mark Shohet & I’m a Portfolio Manager on RBC’s BlueBay Securitized Credit Team.
Last week we observed that the labor market still has some legs and we saw a Consumer Price Index (CPI) report showing some basic necessity components still trending higher; we even heard some hawkish Fed rhetoric about skipping a November cut. A surprisingly resilient US consumer and labor market has led stocks higher and fixed income tighter. But what about rates? While equity markets and credit spreads seem elated by expectations of cuts, the rates market is painting a different picture, taking more seriously the possibility that too hot of a labor market will spoil the rate cut party. The 10-year Treasury Bond is up nearly 50 basis points (bps) since the Fed’s 50 bps rate cut, ending the week above 4%, and the 2-year Bond is within spitting distance of the same level. It’s clear that stronger economic news has delayed the rate cut outlook that was anticipated after the Fed’s September meeting, and we also see a yield curve that hasn’t steepened as some long duration buyers may have hoped for.
While the path of rates is undoubtedly lower, much is priced into the forward curve such that any lag is a positive for floating rate assets. And when those rate cuts do come into fruition, while it may be a negative for investors’ floating rate all-in yields, it’ll be a positive for underlying weaker credits whose issuers will benefit from some breathing room on their floating rate liabilities and thus achieve better interest coverage ratios making Private Equity sponsored sales or Private Credit takeouts more likely. Therefore, maintaining some exposure to floating rate assets in a diversified portfolio strikes us as prudent asset allocation, and that is exactly what we’ve seen from some institutional accounts who have hit the brakes on buying duration or in some cases even swapped back to underperforming floaters because of the higher all-in yields available for example in loans vs. bonds from the same issuer.
There are a few different ways to take advantage of this change in rate expectations. In securitized credit, we continue to see value in short duration floaters such as Collateralized Loan Obligations (CLOs). Investors are handsomely compensated by a flat term curve and inverted forward curve marked by a front-end Secured Overnight Financing Rate (SOFR) close to 5%, all while picking up attractive credit spreads vs. similarly rated assets but with minimal spread duration at the short end of the curve. And despite heavy new issuance, supply continues to be well absorbed particularly due to the number of buyers being refinanced out of bonds who then need to re-engage in the primary and secondary market.
Bottom line, an allocation to floating rate assets may be beneficial in the current environment if central banks are inclined to cut at a slower pace than the market projects. All of this will be further complicated by the results of the US Presidential election in less than a month, as different visions around fiscal spending and tariffs will certainly play a role in monetary policy—including the risk of a pause from the Fed. The direction of rates is indeed lower, but as we’ve seen time and time again this year the path to get there won’t be linear.
As always, thank you for your time.
Summary points
It’s clear that stronger economic news, particularly in the labor market, has delayed the rate cut outlook.
There are several ways to take advantage of this change in rate expectations.
An allocation to floating rate assets may be beneficial in the current environment if central banks are inclined to cut at a slower pace than the market projects.