Bonds come in all shapes and sizes. Floating rate notes largely remove interest rate risk and make great alternatives to deposits as interest is adjusted on a quarterly basis.
What are floating rate notes?
A floating rate note (FRN), sometimes called a floating rate bond, is a security that pays interest or a coupon linked to a variable benchmark. Like other bonds, they have known maturity dates and sometimes a call date when they can be repaid early, but unlike fixed rate bonds where income is absolutely certain, income on a FRN varies.
In Australia, most FRN’s pay income set at a margin over the bank bill swap rate (BBSW) which is the market benchmark rate. The actual income for an interest period will be the fixed rate margin plus the variable BBSW on the first day of that period. The underlying BBSW benchmark rate will rise and fall over time based on interest rate expectations.
The margin over and above the relevant benchmark is usually fixed and set at the time of issue of the bond. It is compensation for the credit risk an investor is taking by investing in the company. A narrow margin implies a low risk entity, while a wide margin is added compensation for a higher risk investment.
Floating rate notes, because of the way they are structured, typically protect a portfolio when interest rates are rising. That is, as the Reserve Bank increases the cash rate to try and slow growth in an economy. FRN income will also increase to reflect the market’s expectations of higher interest rates, thus typically outperforming fixed rate investments such as term deposits and fixed rate bonds under those economic conditions.
The main issuers of floating rate notes in Australia are domestic and international corporations and institutions. The Australian Commonwealth government and states and territories predominantly issue fixed rate bonds, although they also issue inflation linked bonds.
Floating rate notes can also be issued with a step up rate in the event that it is not called (repaid early or there is a trigger event such as a credit rating downgrade.
How FRNs work – an example
Commonwealth Bank issued two bonds, one fixed and the other floating on 12 July 2016.
Floating rate tranche
Interest rate: 3m BBSW +121bps
Maturity date: 12 July 2021
The total issue was A$1.8bn, with the interest rate set at 3 month BBSW plus a fixed margin of 121 basis points. The bond was issued for five years and pays quarterly interest. On the very first day of issue, investors outlay $100 per bond. The 3 month BBSW rate is taken that day and added to the fixed margin of 121 basis points (or 1.21%) to determine the interest rate applicable for the coming quarter.
The very last payment to investors on 12 July 2021 would be $100 face value of the bonds plus interest for the final quarter.
In this example we assume various forward 3 month BBSW rates to illustrate how the bonds work.
Factors that cause the price of an FRN to fluctuate
Once FRNs are issued, they then trade in the secondary market. Prices will move up and down. Some of the reasons for price movements include:
- Accrued interest - As a note gets closer to the interest payment date, it builds up more accrued interest and its price (all other things being equal) will rise. When the interest is paid the price will fall by the amount of the payment and will again start to accrue interest on a daily basis until it is paid on the next payment date (the same is true of fixed rate bonds).
- Short term rate movements - Due to the reset mechanism on the payment dates, FRNs will pay a fixed rate until the next coupon reset date. Therefore, an investor is locked in at the current rate until it resets at the next reset date.
- Traded margin - The most important factor that will cause fundamental changes to the price of an FRN is the movement in the traded margin or spread movement. That is the extent to which the traded margin diverges from the margin set at first issue. It is a reflection of perceived creditworthiness of the company that issued the FRN.
What FRNs can do in your portfolio
There is a very wide range of floating rate bonds available. The lowest risk, senior secured covered bank bonds are often rated ‘AAA’, the same as the Commonwealth government. These bonds have specific security and in the case of a bank, it is 8% of its mortgage loan pool. There are also a number of other clauses in the documentation which give enormous confidence to investors in these bonds.
Moving down the credit rating spectrum, a range of institutions issue FRNs with many Australian bonds issued in the investment grade range of the highest rating of AAA to the lowest investment grade rating of BBB-. To date, few sub investment grade or high yield bonds rated BB+ or below, have been issued. Australian corporations with these ratings have typically gone to the US market.
In recent years, FIIG has issued unrated bonds on behalf of mid sized corporations and these deliver high returns for higher risk.
Some investors have specific needs:
1. Middle Market/ Institutional Investors
This group often need to meet mandates that require minimum holdings related to credit ratings. For example, investments must be minimum Standard and Poor’s equivalent “A” credit rating. Further, some financial institutions need to invest in high quality liquid assets (HQLA) and meet repurchase arrangements with the RBA.
Mandates vary, but common requirements may include:
- Minimum BBB+ credit rating
- Bond is rated by two credit rating agencies
- Various other internal measures which often include a maximum term to maturity
Importantly, by shopping around, investors can pick up additional yield rather than relying on traditional products and with large balances, this quickly adds up.
Sample low risk FRNs available
2. Individual clients
Personal clients don’t have the restrictions that middle market/institutional clients do, allowing them to move up the risk spectrum for higher returns.
Commonly, they will invest in subordinated bank debt which is still investment grade and often rated in the “BBB” range as well as high yield, non rated FIIG originated bonds. Please see a sample of bonds below.
The yield to maturity is quoted assuming forward BBSW projections, but investors should expect this will fluctuate given market expectations of interest rates and the perceived credit risk of the company. The trading margin is the current margin assuming you purchase the bond at its current market price (which can be below or above par $100) and therefore this margin could be more or less that the coupon margin set at first issue.
Sample higher risk FRNs available
Factors to consider when chosing an FRN
- Credit margin – the margin above the BBSW benchmark rate where the FRN is trading in the secondary market for more information see the Glossary below
- Risk appetite - higher risk FRNs will deliver higher returns
- Term to maturity – assuming similar risk profiles, longer dated bonds should deliver higher returns as company performance becomes more uncertain over longer timeframes
- Cashflow – if you know you need cash at a certain future time, you can match that liability with a bond maturity, giving you additional certainty
- Staggering maturity dates in your portfolio, for example having one bond mature each year will provide built-in liquidity
- Existing bond holdings - terms to maturity, issuers, sectors, diversification
- Other investments. Holding deposits, bonds and hybrids in the one entity is too concentrated even if highly rated
- Holding a small proportion in high yield bonds to boost overall returns
FRNs are useful additions to any portfolio and will provide protection, if the market perceives interest rates are going to start to move higher. Importantly, FRNs are tradeable securities allowing investors to access capital if needed. They are particularly useful to those investors who are constantly seeking the best deposit rates and keep maturity dates short to take advantage of any potential higher rate movements.
A security that pays a defined distribution (the coupon), for a given period of time (the term) and repays the face value of the security at maturity. A bond is a loan from an investor to the issuer of the security. There are many types of bonds including; floating, fixed, consumer price index (CPI) bonds, inflation linked, nominal and Eurobonds.
Is the rate of interest paid on a fixed income investment or bond. Coupons can be paid annually, semi annually or quarterly or as agreed in the terms of the security. The coupon rate can be fixed or floating for the term of the security. If it is a floating rate then it is likely that it will be linked to a benchmark such as the 90 day bank bill rate. The coupon rate is set by the issuer based on a number of factors including prevailing market interest rates and its credit rating. Fixed rate bonds in Australia predominantly pay a semi-annual coupon whereas floating rate bonds predominantly pay a quarterly coupon. Indexed linked bonds usually pay quarterly coupons.
For example, a $500,000 bond with a fixed rate semi-annual coupon of 8% will pay two $20,000 coupons each year.
The coupon margin, sometimes known as the issue margin, represents the spread above the variable benchmark (typically 3 month BBSW) paid by the issuer on the FRN. So that if an FRN pays BBSW plus 120 basis points each quarter, then 1.20% (or 120 basis points) is what we refer to as the coupon margin. It is the rate which when added to the BBSW benchmark determines the coupon for that period.
Floating rate note
A floating rate note (FRN) or bond is a security that pays a coupon linked to a variable benchmark. In Australia most FRN’s pay a coupon set as a margin above the bank bill swap rate (BBSW) which is the market benchmark three month interbank rate. The actual coupon for an interest period will be determined at the start of that period by applying the margin to the three month BBSW rate on the first day of the coupon period. The three month BBSW rate will rise and fall over time based on prevailing interest rates. The margin is fixed and will be set at the time of issue
Traded margin (sometimes known as the discount margin, credit margin or credit spread)
The traded margin is the margin above the BBSW benchmark rate where the FRN is trading in the secondary market. The traded margin is the effective margin over and above the BBSW benchmark at which an investor purchases an FRN. The secondary market determines the trading margin that is different from the coupon margin. The traded margin is the actual effective margin you will receive on that FRN if you buy it at the current price and hold it to maturity. The trading margin is a reflection of the creditworthiness and will rise as perceived credit risk increases and fall as creditworthiness improves, all other things being equal.