Inverse Floaters and the Income Stability of a Debt Securities Investment Portfolio

Inverse Floaters and the Income Stability of a Debt Securities Investment Portfolio

David F. Babbel
Financial Services

Inverse floaters are generally thought to be volatile securities. And, standing alone, they may in fact be volatile. If they are used properly in a portfolio context, however, they can serve as hedging vehicles for a buy-to-hold investor concerned with reinvestment income and thereby reduce the income volatility of a debt securities portfolio. This result occurs because, during periods of low interest rates, high coupon payments from inverse floaters offset the lower reinvestment rate, and vice versa. The presence of inverse floaters thereby creates a natural hedge against reinvestment risk.

Using a two-factor interest rate model and Monte Carlo simulations, this study compares the expected income and volatility of seven different investment portfolios: 3-month T-bills, 5-year T-notes, 5-year zero-coupon bonds, 5-year inverse floaters, T-notes plus inverse floaters, and T-notes plus inverse floaters plus repurchase agreements in varying amounts. The simulated results are reinforced by empirical evidence. The simulations and empirical analyses offer several interesting findings. First, under certain investment objectives and risk profiles, inverse floaters can play an economic role in augmenting the level of income as well as stabilizing the income volatility of the portfolio. Second, contrary to the common perception that T-bills constitute a riskless investment, investors could be subject to a substantial degree of reinvestment risk if their investment horizons are longer than the maturity of the invested T-bills.

The objective of this paper is not to argue that a portfolio consisting purely of inverse floaters outperforms other investment strategies, because it does not; rather, the paper seeks to dispel the bad publicity that arose following several municipal financial crises concerning the suitability of these instruments.

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