Riding the rising rate wave with floating rate notes


Karen Veraa, CFA Jun 8, 2022

INTRODUCTION

INTRODUCTION

Bond prices move inversely with interest rates, and with rates rising in 2022, investor bond portfolios may be under water. Those seeking to protect their bonds might reduce risk by holding cash or shorter maturity bonds. Others might adjust their strategy and hold their bonds to maturity. Another option may be to simply trade in your fixed rate bonds for floating ones and invest in “floating rate notes” (FRNs). Let’s review some commonly asked questions about FRNs as we seek to buoy our portfolios against rising rates.

HOW DO FLOATING RATE NOTES WORK?

HOW DO FLOATING RATE NOTES WORK?

FRNs are bonds with “floating” coupons that adjust with changes in short-term interest rates. Most FRNs have maturities of five years or less, but unlike fixed rate bonds, they tend to have very little interest rate sensitivity due to their flexible cash flows. The short-term reference rate can vary, but three-month LIBOR was the most common historically. FRNs do have credit risk, so the coupons include a fixed “credit spread” (additional yield to compensate investors) that is set at issuance.

Each reset period, the coupon will adjust based on the change to the reference interest rate:

Illustration of quarterly coupon reset

Caption:

Example of quarterly coupon reset.

Time periodReference Rate(ex: 3-month LIBOR)Fixed SpreadCoupon
Coupon at issuance =1.00%0.50%= 1.50%
Coupon at 1st Reset =1.25%0.50%= 1.75%
Coupon at 2nd Reset =1.50%0.50%= 2.00%

FLOATING RATE NOTE YIELDS CHANGE WITH SHORT-TERM RATES

chart

Source: Bloomberg, as of 4/30/22. Floating rate note yield represented by the yield to maturity of the Bloomberg Floating Rate Note <5 years Index. Fed funds target rate is upper bound of target range. Index yield is for illustrative purposes only.  Indexes are unmanaged and one cannot invest directly in an index. Past performance is no guarantee of future results.

Chart description: A line chart showing the daily yield to maturity of the Bloomberg Floating Rate Note <5 Years Index for 10 years, compared to the upper bound of the Fed Funds target rate range.


HOW HAS THE FLOATING RATE NOTE MARKET CHANGED SINCE LIBOR IS BEING PHASED OUT?

HOW HAS THE FLOATING RATE NOTE MARKET CHANGED SINCE LIBOR IS BEING PHASED OUT?

LIBOR – the London Interbank Offered Rate – serves as the benchmark for hundreds of trillions of dollars of financial instruments. However, LIBOR Reform is currently in progress with some of the LIBOR fixings halted in December 2021, such as the one-month and twelve-month tenors.  The most commonly used tenor is three-month LIBOR, which will continue to be quoted until June 2023.

 

The market is largely replacing LIBOR with the Secured Overnight Financing Rate (SOFR).  SOFR is calculated daily using trades of treasury securities, so it is based on real trade data, not quotes or estimates.1 Many corporate issuers have started issuing FRNs linked to SOFR, and index providers began adding these SOFR linked bonds to their indices in April 2019. Today, over half of the bonds in the Bloomberg Floating Rate Note <5 Years Index are linked to SOFR.2

 

Many LIBOR linked bonds with maturity dates beyond June 2023 include provisions to designate an alternative reference rate (ARR) when LIBOR is no longer calculated. These bonds may use SOFR or another rate to calculate future coupons. These details are known as “fallback language” and can be found in the bond’s legal documents.

ARE FLOATING RATE NOTES THE SAME THING AS BANK LOANS?

ARE FLOATING RATE NOTES THE SAME THING AS BANK LOANS?

No. Bank loans or “leveraged loans” are often confused with FRNs because they also have floating rate coupons. However, bank loans have different liquidity and credit quality profiles, and there is typically no issuer overlap between these markets. Both bank loans and FRNs can be used to navigate a rising rate environment, but the choice between the two depends on each investor’s risk tolerance and liquidity needs:

Comparison of floating rate notes and bank loans

Caption:

Comparison of floating rate notes and bank loans.

Floating rate notesBank loans
Credit qualityPrimarily investment gradePrimarily below investment grade
SecuredTypically unsecuredTypically secured by issuer
IssuanceBonds issued in the capital marketsLoans typically arranged by syndicates of commercial or investment banks
SettlementSettle on trade day + 2 daysSettlement times vary (range from 5-40+ days)

The above table is for illustration purposes only. It serves as a general summary and is not exhaustive. It does not apply to every single product. Please refer to the relevant prospectus for further details.

HOW DO INVESTORS USE FLOATING RATE NOTES IN A PORTFOLIO?

HOW DO INVESTORS USE FLOATING RATE NOTES IN A PORTFOLIO?

FRNs can be used in an effort to reduce overall portfolio duration. Since their coupons reset, FRNs typically have duration – or interest rate risk – that is very close to zero. By contrast, the fixed rate corporate bond market has a duration of 7.5 years, implying that if interest rates rise by 1%, those bonds could fall by 7.5%.3 Additionally, FRNs can be used to put cash to work and potentially earn a higher yield than cash equivalents. Today, the Bloomberg Floating Rate Note <5 Years Index yields 1.68%, which is significantly higher than the average Money Market Fund yield of 0.08%.4

HOW CAN I INVEST IN FLOATING RATE NOTES?

HOW CAN I INVEST IN FLOATING RATE NOTES?

iShares Floating Rate Bond ETF (FLOT) offers exposure to investment grade FRNs with less than five years to maturity. FLOT currently holds over 400 FRNs from 160 unique issuers and has an expense ratio of just 0.15%, making it an efficient way to access the FRN market.5 Investors can add FLOT to their bond portfolios to help keep their bond portfolios afloat during the current rising rate environment.

Karen Veraa, CFA

Karen Veraa, CFA

Head of U.S. iShares Fixed Income Strategy

Tom Fickinger, CFA

Fixed Income Strategist

Contributor