A floating-rate note (FRN) is a debt instrument with a variable interest rate, unlike the fixed rate used for traditional bonds. The FRN interest rate is tied to a benchmark rate, such as the Canadian Dealer Offered Rate (CDOR), the Federal Reserve’s federal funds rate, the London Interbank Offered Rate (LIBOR), or the prime rate.
Floating rate notes are issued by financial institutions, governments and their agencies, as well as corporations, and typically have maturities between two and five years.
Floaters usually pay a lower yield to investors than their traditional bonds because their coupon rates are benchmarked to short-term rates. The investor gives up a portion of the yield for the security of having an investment that will pay them more as the benchmark rate rises. However, if the benchmark falls, so too will the rate on the FRN.
Other floater facts
Floaters protect bond investors from inflation and volatility, which (at the time of writing in May 2002) have been ravaging North American bond and equity markets. This is because the bond’s interest rate is adjusted or reset based on current market conditions.
Overall, FRN prices tend to exhibit less volatility or fluctuation than traditional bond prices.
The flipside of this is a more uncertain income stream, which might not work for some investors. The other potential issue with floaters is that investors are subject to default or credit risk with any non-government issues.
Duration is not your friend right now
Investors must appreciate the impact rising interest rates have on their bond holdings – when rates go up, bond prices fall. And, the longer a bond or bond fund’s duration, the greater those losses will be. The conventional wisdom is to keep your bond duration short during periods when interest rates are expected to rise.
Many floating rate notes have quarterly coupons, meaning that interest payments are made four times a year, but it could be monthly, semi-annually, or annually. Floaters don’t decline in value if interest rates rise, but instead FRN holders benefit by receiving higher coupon payments.
FRN coupons are adjusted on a monthly or quarterly basis and because of this reset, floaters have very limited duration. The length of time to the next coupon reset is the extent of duration risk with floaters, which makes them particularly appealing to investors during periods of rising interest rates. Conversely, floaters will underperform if short-term rates decline or remain unchanged.
Here we go again
In the current climate, it would make sense to own floating rate notes (as this lowers duration and insulates investors from expected increases in market yields. And make no mistake, higher yields are coming as central banks around the world raise interest rates in order to rein in inflation.
Fixed income manager Canso Investment Counsel Ltd. was already advocating for the value of floaters in a rising rate environment, back in 2015 and 2016 — and the same applies today.
“The devastating impact long duration can have on a portfolio in a rising rate environment combined with a relatively flat yield curve gives a bias to higher quality floating rate notes.”
“Our bottom up fundamental relative value approach dictates that we are keeping duration as short as allowed through the use of investment grade floating rate notes.”
What floaters are not
Floaters are not a substitute for short-term investment-grade bonds or cash. Even though some financial advisors will recommend ultra-short-term bond funds and bank loan funds (also called floating-rate or senior-loan funds) as if they were substitutes for cash, they’re not.
Floaters are typically geared towards institutional investors. Individual investors will be able to access mutual funds and ETFs that incorporate them in their holdings, but will find it challenging to access them directly and the minimum investments will be quite steep.
During periods of turmoil in the equity markets, rates are likely to fall as investors rush to safety, so high-quality conventional bonds might prove to be the better diversifier in a balanced portfolio.
Don’t exceed your tolerance for risk
The best advice for investors in the face of rising interest rates is to understand how your portfolio is structured so you know your overall risk exposure. And you must ensure that your investments align with your personal risk tolerance so you can stick to the plan during these unavoidable market corrections. Floaters can certainly help mitigate some risks during periods of rising rates, but to mitigate is not the same as to eliminate.