As the Reserve Bank of Australia (RBA) pivots and joins other major central banks tasked with aggressive rate hikes to tame rising inflation, floating rate notes are having their moment in the sun. Here we look at the benefits of these types of bonds in a rate rising environment.
Some of the current attractive floating rate bonds include*:
As investors reassess their portfolio allocations, evident by the ASX 200 entering a correction as investors rotate out of equities and the government bond yield curve shifts higher, it’s timely to ask if there is an investment option that has added upside from rate hikes?
Floating rate notes (FRNs) largely remove interest rate risk and make great alternatives to deposits as interest is adjusted on a quarterly basis. They also provide an enhanced income stream in a rate rising environment.
An FRN, sometimes called a floating rate bond, is a security that pays interest or a coupon linked to a variable benchmark. In Australia, most FRNs pay income set at a margin over the 3-month Bank Bill Swap Rate (or 3M BBSW), which is the market benchmark rate. The actual income for an interest period will be the fixed issue margin plus the variable 3M BBSW on the first day of that period.
The underlying 3M BBSW benchmark rate will rise and fall over time based on interest rate expectations.
The chart below shows the steady increase in the 3M BBSW as the market ‘prices in’ rate hikes in anticipation of them occurring. The coupons on FRNs will increase with an uplift in the 3M BBSW, increasing the periodic income.
Also, because of the way FRNs are structured, they typically protect portfolios when interest rates are rising. As they are responsive to market conditions, their prices are more stable than fixed rate or inflation linked bonds, which is an attractive feature for investors who may want to sell prior to maturity.
*Pricing correct as at 24 June 2022.
(W) denotes Wholesale only availability.
(R) denotes Retail and Wholesale availability.
Please note yields shown on Floating Rate Note (FRN) securities are projected yields based on its margin over swaps at time of pricing.