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The One Investment You Must Own When the Fed Raises Interest Rates

Last Friday, I shared why hyperinflation is going to be nothing more than a phantom menace. But that doesn’t mean the Federal Reserve can hold interest rates at 0.25% indefinitely.

A modest amount of inflation is bound to return. And when it does, in addition to owning stocks, you’ll want to make sure you own senior secured floating rate (SSFR) bonds.

Never heard of them? Don’t worry. I’m going to run down the benefits and show you an easy way to get involved because they’re ideally suited for the current environment.

Here’s why…

When Interest Rates Rise, Buy These Bonds

If we look back over the last three periods when the Fed raised interest rates, the reason to own SSFRs is clear.

So what explains the outperformance? It’s simple, really.

Unlike traditional bonds, the interest payments on SSFRs reset every 30 to 90 days – by a predetermined amount – to reflect changes in a base interest rate. For example, this could be the U.S. Federal Funds Rate or the London Interbank Offered Rate (LIBOR).

So if the benchmark LIBOR is 3% and the bond promises to pay 2% more than LIBOR, the interest rate will initially be set at 5%. Ninety days later, if LIBOR increases to 3.5%, then the interest on the bond will reset to 5.5%, and so on.

Compare that to a fixed-interest rate bond, which pays 4% at the outset. It will never pay more than that 4%, regardless of how high (or fast) interest rates climb.

Ultimately, the simple adjustment feature means SSFRs aren’t subject to significant price erosion as interest rates rise. Instead, prices remain stable. Even better, the income that the bonds generate actually increases as interest rates climb.

That in itself means SSFRs offer a powerful combination of price stability and higher income, which makes them the ideal bonds to own during a rising interest rate environment.

But that’s not all…

Two More Notable Advantages of SSFRs

Even in the event of a bankruptcy, SSFRs offer more protection than traditional bonds. Why?

Because senior loans are secured by tangible assets like cash, accounts receivables, inventory, buildings, equipment, trademarks, or patents. Therefore, recovery rates are much higher.

The proof? According to Credit Suisse, recovery rates on senior loans since 1995 averaged $0.70 on the dollar compared to $0.43 for typical junk bonds.

Another benefit of SSFRs is the fact that they exhibit a rare negative correlation with U.S. Treasuries. That means if Treasuries decline in value, which they will once the Fed starts raising rates, senior loans should move higher.

So you have inflation protection, reduced risk and additional portfolio diversification to boot. Good luck finding the same three qualities in any other investment.

Before you rush out to buy individual SSFRs, though, let me offer a word of caution…

Don’t Fly Solo

I’d be remiss if I didn’t warn you that while recovery rates average $0.70 on the dollar, that’s not a guarantee. If the company that issues an SSFR goes belly-up, so could your entire investment.

That’s why instead of investing in individual SSFRs, I recommend that you spread your risk and go with a well-diversified, mutual fund. For example, the Eaton Vance Floating Rate Fund (EABLX).

It invests in hundreds of SSFRs at once, which ensures that the impact of any bankruptcy is minimal. It also provides daily liquidity and pays a monthly dividend.

Bottom line: It’s not a matter of “if” the Fed raises interest rates… it’s “when.” And when that happens, yields on SSFRs are guaranteed to increase, too. That’s why they’re my favorite alternative way to hedge against inflation.

So if your portfolio is heavily weighted to traditional bonds, it might be time to consider reallocating some funds into SSFRs for protection.

Ahead of the tape,

Louis Basenese

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