Wednesday 23 September 2020 by Jonathan Sheridan Floating_rate_note_800 Education (basics)

Floating rate notes - is now a good time?

Floating rate notes are usually preferred when interest rates are rising due to the variability in income, which rises along with market rates.

We look at why we are comfortable with them even in a low rate environment.

Recap - 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 an 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 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.

Why floating rate notes now?

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.

However, there is really a negative argument for not owning floating rate notes in a period of falling interest rates rather than owning them in rising rate environments.

We are currently in a situation where the RBA (and other global central banks) have made it clear that interest rates will remain near zero for an extended period. This therefore gives owners of floating rate notes comfort that market rates are not likely to go lower for a significant time, providing a floor to returns.

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How FRNs work – an example

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.

NAB issued two bonds, one fixed and the other floating on 18 November 2019.

Floating rate tranche
Volume: A$1.175bn
Interest rate: 3m BBSW +202bps 
First call date: 18 November 2026 

The total issue was A$1.175bn, with the interest rate set at 3 month BBSW plus a fixed margin of 202 basis points. The bond was issued for six 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 202 basis points (or 2.02%) to determine the interest rate applicable for the coming quarter.

The very last payment to investors on 18 November 2026 would be the $100 face value of the bonds plus interest for the final quarter.

In this example, we look at the historical 3 month BBSW rates since issue to illustrate how the bonds work.

Floating_rate_note_diagram_1

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:

  1. 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.
  2. 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.
  3. 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.

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 typically 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-.

In the high yield sub investment grade or unrated universe, fewer FRNs have been issued as investors and issuers typically prefer the certainty associated with a fixed coupon if rates are higher.

Since 2012, FIIG has arranged the issuance of >$2.5bn of unrated AUD bonds, about a quarter of which have been floating rate.

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 Poors 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:

  1. Minimum BBB+ credit rating
  2. Bond is rated by two credit rating agencies
  3. 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.

2.   Private Clients

Private clients do not 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, unrated 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 than the coupon margin set at first issue.

Floating_rate_note_table_1_NEW

Factors to consider when choosing an FRN

  1. Credit margin – the margin above the BBSW benchmark rate where the FRN is trading in the secondary market
  2. Risk appetite – higher risk FRNs are expected to deliver higher returns
  3. Term to maturity – assuming similar risk profiles, longer dated bonds should deliver higher returns as company performance becomes more uncertain over longer timeframes
  4. 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
  5. Staggering maturity dates in your portfolio - for example having one bond mature each year will provide built-in liquidity
  6. Existing bond holdings – terms to maturity, issuers, sectors, diversification
  7. Other investments – holding deposits, bonds and hybrids in the one issuer (e.g. a major bank) is likely too concentrated even if highly rated
  8. Diversification – holding a small proportion in high yield bonds to boost overall returns

Summary

FRNs are useful additions to any portfolio and will provide protection, if the market perceives interest rates are going to start to move higher. Additionally, when rates are at or near the zero bound as they are now, and with the RBA having made a strong case for not taking rates negative, there is an effective floor under the rate to be received.

Therefore, all other things being equal, this should be a good entry point for FRNs as income returns are likely to only go up from this point.

Importantly, FRNs are typically tradeable securities like any other bond, allowing investors to access capital if needed. They are particularly useful to those investors who are constantly seeking the best term deposit (TD) rates and keep TD maturity dates short to take advantage of any potential higher rate movements, as FRNs reset every quarter and so do this automatically, while paying a higher return than a deposit for a slightly higher risk.