With investors continuing to look for ways to hedge against potentially rising interest rates, we’ve been getting a lot of client questions about floating rate notes (FRNs), and have been seeing increased interest in the iShares Floating Rate Note ETF (FLOT). Since the beginning of the year FLOT has doubled in size, gathering $392mm in new inflows and bringing the total AUM to $789mm as of 3/1/2013.
As their name suggests, FRNs are investment grade bonds that pay a floating rather than fixed rate coupon. Since the coupon is adjusted with changes in interest rates (usually a short-term rate like the 1-month or 3-month LIBOR – see below), the bonds tend to be less sensitive to rate changes than securities with fixed interest rates. When LIBOR increases, (which tends to occur when the Fed is going through a tightening cycle) the coupons on floating rate notes will increase. For this reason, we often see investors considering FRNs when they want to reduce their overall exposure to interest rate risk, but favor investment grade credit risk.
Floating Rate Note Coupon vs. Fed Funds Target Rate and 3 Month LIBOR
Clients often ask us to explain how FRNs differ from bank loans (sometimes called floating rate loans or leveraged loans). While they share a few similar characteristics, it’s important to understand the differences between them – particularly since most “floating rate” funds are actually bank loan funds. Both instruments pay a coupon that adjusts with changes in short-term rates (primarily 3 month LIBOR), and coupons typically reset on a quarterly basis. The key difference is that FRNs are typically investment grade, whereas most bank loans are rated below investment grade (e.g. high yield). Because of this, bank loans have the potential for higher yield, but of course this comes with greater credit and liquidity risk. Below is a more comprehensive view of the differences between the two securities.
|CHARACTERISTIC||FLOATING RATE NOTES||BANK LOANS|
|Issuance||Bonds issued in the capital markets||Loans typically arranged by syndicates of commercial or investment banks|
|Level of Security||Typically unsecured||Typically secured by the issuer’s collateral|
|Credit Rating||Typically investment grade||Typically below investment grade|
|Coupon Type||Pay a floating rate coupon||Pay a floating rate coupon|
|Settlement||Settle on trade day +3 days||Settlement times vary (range from 5 to 40+days)|
Bottom line: If you want to insulate a portfolio against interest rate changes, or you want exposure to investment grade bonds with less interest rate risk, floating rate notes may be worth a look. Additionally, FRNs can be a compelling alternative to money market funds if you’re seeking the potential for more yield and you’re willing to take on a bit more risk. Particularly in today’s market environment, where yield is scarce and fears about rising rates abound, FRNs may be the solution you never knew you needed.
Source: Barclays Capital, Bloomberg
Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. Narrowly focused investments typically exhibit higher volatility and are subject to greater geographic or asset class risk. FLOT’s income may decline when interest rates fall because most of the debt instruments held by the fund will have floating or variable rates.