Tuesday 03 June 2014 by FIIG Securities two-giraffe Education (basics)

Three types of bonds: Part 2 - Floating rate notes

This is the second article in a three part series. Combined, the articles explain that bonds are appropriate investments across all economic cycles

There are three different bonds that work best under different economic conditions:
  1. Fixed rate
  2. Floating rate
  3. Inflation linked

It is important to hold an allocation to all three bonds for protection, as investors can never be sure that interest rates will not move higher or lower or that inflation will spiral. However, the portfolio weighting may change depending on the investor’s view of interest rates.

A floating rate bond or more commonly termed a floating rate note (FRN) is a security that pays interest linked to a variable benchmark. In Australia, the benchmark is usually the bank bill swap rate (BBSW) which moves up and down (or “floats”) with movements and expectations of the RBA cash rate.

Interest on FRNs is set as a fixed margin over the benchmark. For example, the interest rate on the new Rabobank senior floating rate bond with expected maturity of 11 February 2020 is quoted as 3 month BBSW + 1.05%.

The interest for the quarter is determined at the start of the period by applying the margin to the underlying benchmark on the first day of the interest period. In the case of the Rabobank FRN, the benchmark BBSW was 2.385% on the day of first issue so the interest for the first quarter was 2.385% +1.05% = 3.435% per annum equivalent.

At the start of the second quarter, the benchmark BBSW rate is reset and the same 1.05% margin added to calculate the interest payment for that quarter, and this process will continue on a quarterly basis until maturity. At maturity, the last interest payment plus the original face value of the investment will be paid.

Over the five years until maturity, the underlying BBSW will rise and fall based on prevailing interest rates.

FRNs, because of the way they are structured, typically protect a portfolio when interest rates are rising.

That is, as the RBA increases the cash rate to try and slow growth and/or address inflation in an economy.

FRN interest payments 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 in rising interest rate environments.

FRNs are more capital stable than fixed rate bonds. That is, FRN prices do not tend to fluctuate as much from the $100 issue price given their interest rates are more aligned to market expectations at any given time, unlike fixed rate bonds whose interest rates do not change for the life of the bond.

The main issuers of FRNs in Australia are domestic and international corporations. The Australian Commonwealth government and states and territories predominantly issue fixed rate bonds, although they also issue inflation linked bonds.