Tue Feb 05 13:00:00 GMT 2019
Corporate floating rate notes (“FRNs”) are investment-grade bonds issued by corporations that have a variable interest rate, which is tied to a benchmark such as the U.S. Treasury bill rate, LIBOR, the Fed funds rate, or the prime rate. Because their coupons adjust with changes in short-term interest rates, FRNs are often used to help reduce interest rate risk during periods of rising rates. FRNs typically have two- to five-year maturities.
Floating rates allow investors to earn the prevailing market interest rate plus a fixed spread while reducing the risks associated with rising rates. Corporate FRN coupons are adjusted on periodic reset dates determined by the issuer. The new coupon is calculated by adding a fixed spread—determined at issuance based on the issuer’s credit risk—to the current reference rate (e.g., LIBOR). The fixed spread remains constant over the life of the note. Typically, the wider the spread, the riskier the FRN. Most investment-grade corporate FRNs make coupon payments quarterly, allowing investors to benefit from rising rates relatively quickly.
Traditional fixed-rate bond prices are inversely related to interest rate movements—when interest rates rise, bond prices fall, and vice versa. The amount the bond’s price falls depends on its duration, which in simplest terms is a measure of the bond’s sensitivity to changing interest rates. Because an FRN’s coupon adjusts with short-term interest rates, it tends to have a duration close to zero. Although FRNs are not completely hedged against interest rate risk, their prices remain relatively stable over time compared to fixed-rate bonds.
Most corporate floating rate notes carry an investment-grade credit rating, meaning credit agencies consider these issuers less likely to default on their payments. This feature makes them different from bank loans, which are floating rate notes that are often considered “speculative” or “junk” due to the meaningful credit risk they carry.
Many FRNs are issued with a cap, a floor, or both. A cap determines the maximum interest rate an issuer will pay despite the level interest rates rise. Conversely, a floor guarantees that the issuer will pay a minimum interest rate, even if the coupon payment calculated by the reference rate is lower. Caps and floors aim to limit an investor’s upside and downside potential, respectively.
Typically, the best time to invest in FRNs is when short-term interest rates are relatively low and expected to rise. In a rising rate environment, their variable rate feature makes them ideal for investors focused on capital preservation and keeping pace with inflation. FRNs may also be appropriate for shorter-term cash management solutions.
Dan Skolochenko is a fixed income portfolio manager and trader in the CIBC Private Wealth Management San Francisco office, with more than 20 years of industry experience.
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