We have come a long way from the “zero interest rate policy” implemented by the U.S. Federal Reserve in the aftermath of the financial crisis. Today, the Fed Funds target rate, the rate it pays banks on excess reserves, is in the range of 1.75–2.00%. The Fed is widely expected to raise rates at least one more time this year following a 0.25% hike on June 13; that would put the target in the range of 2.00%-2.25%, a level not seen since 2008. (Source: FRED/St. Louis Federal Reserve.)
One of the ways that investors can help navigate a rising rate environment is through exposure to bonds with coupons that adjust, or float, with short-term interest rates. These adjustments mean investors are not exposed to potential price losses, and can also benefit from income increases as rates rise over time.
Understanding floating rate notes
While there are several types of debt instruments with variable interest rates, such as bank loans or variable rate demand notes (VRDNs), floating rate notes (FRNs) are growing more popular with investors. These investment-grade bonds, issued primarily by corporations, have coupons that periodically reset using a short-term interest rate and typically have maturity dates ranging from 18 months to five years. Most floating rate notes pay coupons quarterly, but a few pay monthly.
How are coupons reset?
FRN coupons are adjusted on periodic reset dates, typically three months after the bond was issued. The coupons are calculated based on the following formula:
Coupon = Reference Index Rate + Fixed Spread
The reference index is a short-term interest rate, typically the 1-month or 3-month London Interbank Offer Rate (LIBOR). LIBOR is the rate an international bank would charge another bank for a short-term loan, so it tends to be higher than the Fed Funds target rate.
The fixed spread is determined at the time of issuance, and is based on the market’s perception of the issuer’s credit risk. The fixed spread does not change over the life of the bond.
Here’s an illustration of how resets might work.
Floating rate notes versus bank loans
Investors might be familiar with bank loans or leveraged loans, which are high-yield loans that also have coupons that reset with 3-month LIBOR. The popularity of these instruments has grown over the past decade, as investors sought higher yields when rates were exceedingly low. While FRNs and bank loans both offer floating interest rates, they have key differences in terms of credit quality and liquidity.
Floating rate notes in a portfolio
Investors can use FRNs to help manage risk and return in a rising rate environment, by making adjustments to their portfolios:
1. Put cash to work
Investors who use cash equivalents in an effort to protect portfolios from rising rates run the risk that their income might not keep pace with inflation. Floating rate notes may offer more income to help maintain purchasing power, although it’s important to note they don’t have protection of principal as a bank deposit or money market fund would.
2. Reduce portfolio duration
The duration, or interest rate sensitivity, of floating rate notes tends to be very short, as the bond’s coupon regularly resets. The Bloomberg Barclays Floating Rate Note <5 Years Index had a duration of 0.15 years as of May 31, 2018, meaning it carries very little exposure to interest rate risk. By comparison, core bond indexes like the Bloomberg Barclays U.S. Aggregate Index had a duration of 5.95 years. (Durations are from Bloomberg.)
3. Gain exposure to short-duration credit
FRNs offer access to corporate debt, which may generate more income than a similar maturity U.S. government bond. However, U.S. government bonds are generally considered to have less credit risk.
Exchange traded funds, such as iShares Floating Rate Bond ETF (FLOT), are a convenient, low-cost way to add diversified exposure to a bond portfolio, while managing interest rate risk in a rising rate environment.