Floating Rate Notes are back in the news. Here's our take.
1. What are they? Floating Rate Note (FRN) funds come out to play whenever there’s a whiff of interest rate hikes in the air. They are bonds that reset their coupon as rates move. So, if the initial coupon is 4%, they may move to 5% if rates rise or 3% if rates fall. The price of the FRN (or floaters) will, therefore, be less volatile than a normal bond because the reset reflects current conditions. Nice. The price should stay around par value. What could possibly go wrong?
2. Who issues them? Typically governments, financial companies and industrial companies. For governments, it's a cheaper way to borrow for short periods and for financials, the liability of the coupon payment (i.e. it goes up and down) is very similar to the income of their assets (i.e. bank deposits). That’s not always the case for a manufacturing company.
3. How often do rates reset? First, understand that the reset period and the coupon period are independent. Coupon payments may be quarterly, semi-annual or annual. Reset periods are mostly quarterly but can be daily or annually and pretty much everything in between.
4. What determines the reset? For U.S. Treasury FRNs it's relatively easy. The rate calculates as a spread from recent T-Bill rate auctions. Recent spreads have been in the range of 4bps to 7bps. As of writing a U.S. FRN maturing in October 2018 yields around 1.36% and a three-month T-Bill yields 1.25%.
For corporate bonds it’s more complicated and many FRNs are tied to a LIBOR (London Interbank Offered Rate and see below) spread and is often called “the index.”
5. What are some examples of FRN? Let’s look at three examples. Some are quite straightforward. So first up, the Goldman Sachs FRN November 2018, which is a large component of the Bloomberg Barclays FRN <5 Years Index. It has a BBB rating and pays a coupon of three months LIBOR plus 1.1% and has a yield to maturity of 2.19%. It’s a senior note and non-callable. For the last twelve months, the price has been between $100 and $101.
6. Got it! And another? But to provide investors with a higher yield, things become more complicated. So for number two, let’s look at a major FRN fund’s largest holding, which is First Data Corporate New Dollar Term Loan, 3.00%, 7/08/22. There are several things to note here:
- It's a term loan, which means it’s a loan originated by a bank and then sold to investors.
- It's not tied to LIBOR but to ABR (Alternative Base Rate), which is a mix of LIBOR, Fed Funds and the prime inter-bank rate.
- It’s not rated. This doesn't mean it's a bad credit just that given the amount of the loan, at $725m, a credit rating was probably too expensive.
- It comes with covenants, which lower the payment to investors if the company’s EBITDA falls below a certain ratio.
- It's thinly traded and is a Level 3 asset. This means there is no observable price (like a trade) so values can only be calculated using estimates or risk-adjusted value ranges
7. Are there mortgage or asset backed FRNs? Indeed there are, which brings us to our third example. One high quality FRN fund that holds Federal Home Loan Mortgage Corporate FRN of 25 Feb 2046 looks like this:
- It’s backed by individual Adjustable Rate Mortgages or ARMs and by FNMA
- It has a floor rate of 0% and is based off LIBOR 1-month. They can change the index any time
- It's subject to the normal pre-payment risk and the experience of the underlying mortgages.
8. LIBOR is going away, so what happens to FRNs? The end is coming for LIBOR after banks manipulated the rate. It used to be that banks would report the demand for inter-bank funds, in any currency, take a daily average and publish the LIBOR rate. But with LIBOR going away in 2021, it looks like each country will take its own approach. Meanwhile, there is confusion all round. In the U.S., the Fed thinks there is no trading in about half of the standard LIBOR notes. This is why funds have to use Level 3 pricing. The Fed has yet to come up with a solution.
Bondholders could be at risk because if there is no LIBOR rate, issuers will use a “fall back rate” which will be the last, and increasingly stale, LIBOR rate. So if rates increase, investors could be left with low paying bonds and prices will adjust down.
9. What has been the experience of FRN funds? Funds holding high quality rated floaters pay a little more than money market funds and should have a stable NAV. The trouble begins when funds chase yield and buy lower quality assets. Here’s a chart:
One of the promoted benefits of FRNs is low correlation to other fixed income assets and low volatility of principal. As you can see in 2008, rates fell and the recession began to bite. The problem with the FRNs was that credit fears took over, default fear rose and the price of the two FRN funds shown fell some 20%.
The next problem was in early 2016 when rates began to rise but the FRNs rate reset was slow to follow. So fund investors were left holding a lower rate bond at a time when rates were increasing. This time the price decrease was around 5% to 10% depending on the fund. Meanwhile benchmark long bond (the blue line) increased in price.
10. And performance? Here’s a quick recap through November 16th 2017:
So what can we conclude?
- FRNs should have a stable price but many don't especially if the credit cycle is deteriorating or rates are rising fast
- Stretching for yield often means credit quality declines.
- Many of the securities are illiquid or use Level 3 pricing.
- The higher the quality of the FRN fund, the more it's likely to concentrate on financial stocks. The Bloomberg Barclays FRN <5 Year index has 65% invested in financials.
- FRN funds seem not to have performed better than high quality bond funds in both rising and declining rate environments despite taking i) more concentration and ii) credit risk and iii) less interest rate risk.
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All charts from Factset unless otherwise noted.