Time to Float? The Investment Case for Floating Rate Notes

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June 20, 2011 11:51am NYSE:FLOT

Matthew Tucker:  With QE2 winding down at the end of June, many analysts and investors are speculating that the end of the purchases may signal the beginning of a tightening cycle, creating concerns about rising interest rates. Since fixed rate bond prices decline when interest rates rise,

 this has prompted many investors to buy shorter duration securities to help protect their fixed income portfolios from rate increases. Another solution that investors may consider are floating rate notes (FRNs), which can help investors reduce their exposure to interest rate increases.

FRNs are bonds that have coupons which reset periodically with changes in short-term interest rates. When the bond is issued, the coupon rate is equal to the short-term interest rate plus a fixed spread.  The coupon is adjusted on the reset date. Most FRNs adjust with changes to the 3-month London Interbank Offer Rate (LIBOR) on a quarterly basis (LIBOR is the rate an international bank would charge another banking institution to borrow from it for a certain period of time). As short-term interest rates increase, the coupon rate on an FRN will increase. The chart below illustrates how the bonds react to changes in interest rates.

Source: Bloomberg
Index returns are for illustrative purposes only. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

So what are the risks of investing in FRNs?  While interest rate risk is reduced since the coupons are floating, the securities are unsecured obligations of the issuer – which means that FRNs are exposed to the credit risk of the issuer.  Although these securities tend to trade near par, they can decline in value when credit risk increases.  For example in 2008, FRNs traded down to an average price of $93.55 when credit spreads widened.

One important thing to note about FRNs is that they are not the same thing as floating rate loans, also called bank loans or leveraged loans (although they are sometimes mistaken for each other).  As the name suggests, bank loans are loans made by financial institutions to high yield companies.  Like FRNs they pay a variable coupon, but bank loans are typically less than investment grade and are not bonds issued into the capital markets.  Some bank loan mutual funds use the term “floating rate” in their names, which can create confusion over what the product is actually investing in.  With the proliferation of products that offer access to FRNs and bank loans, it’s important that investors understand the differences.

The bottom line: Why would investors consider a floating rate note?

  • The ability to gain exposure to credit with less interest rate exposure, as the value of floating rate bonds fluctuates much less in response to market interest rate movements than the value of fixed-rate bonds
  • An opportunity to reduce overall interest rate risk in the portfolio
  • A diversifier within a traditional fixed income, as well as multi-asset class portfolio

ETFs provide a compelling solution for investors looking to access FRNs.  Investing in bonds can be tricky for an individual investor (check out our recent video post on my own personal experience with this), but because ETFs trade on an exchange, they offer more accessibility and price transparency than what can be found in the over-the-counter fixed income market.  The iShares Floating Rate Note Fund (NYSE:FLOT) is the latest ETF to round out our fixed income suite.

For more information on FLOT, go here.

When comparing bonds and ETFs, it should be remembered that management fees associated with ETFs are not borne by investors in individual bonds.

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. The iShares Floating Rate Note Fund is subject to credit risk, which refers to the possibility that the debt issuers will not be able to make principal and interest payments. The Fund’s income may decline when interest rates fall because most of the debt instruments held by the Fund will have floating or variable rates. Diversification may not protect against market risk.

Written By Matthew Tucker From The  iShares Blog

Matthew Tucker has spent the past 16 years focused on fixed income analytics, portfolio management and strategy. As managing director of U.S. fixed income strategy at BlackRock, Inc., and a member of the Fixed Income Portfolio Management team, Mr. Tucker leads both product strategy for ETFs and North America and Latin America iShares strategies, as well as product delivery and client sales. He previously worked with Barclays Global Investors before it merged with BlackRock, and he led the U.S. Fixed Income Investment Solutions team responsible for overseeing product strategy for active, index, enhanced index, iShares and long/short products. Mr. Tucker was also a portfolio manager and a trader in fixed income focused on U.S. government securities.

He began his career at Barra, where he supported clients using the company’s fixed income analytics. Mr. Tucker holds a bachelor of business administration degree from the University of California, Berkeley, and is a Chartered Financial Analyst charterholder.

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