Income: Using floating rate notes as alternative to mainstream fixed income
4 January 2018
Darius McDermott, managing director, FundCalibre, looks at the benefits of this often overlooked means to achieve income.
Following the first interest rate hike in a decade, in November 2017, the Bank of England’s governor Mark Carney has indicated that another two hikes may be required over the next three years to control inflation.
A rising interest rate environment poses a challenge to investors who require exposure to fixed income. They will no longer be able to rely on the dynamics that have driven the performance of bonds over the past decade.
Gilts and other debt instruments, such as investment grade and high yield corporate bonds, are sensitive to interest rate movements. Loose monetary policy has caused the prices of government bonds and corporate credit to rise and yields to fall. Higher interest rates, on the other hand, are likely to cause yields to rise and prices to fall, resulting in capital losses.
How can investors overcome this price risk? The usual answer is either short duration or high yield – both of which remain valid options. But there is another useful alternative to mainstream fixed income: floating rate notes.
These are debt instruments, typically issued by financial institutions, supranationals (like the European Investment Bank) and governments. As the name implies, floating rate notes differ from other fixed income securities by having a variable – or floating – coupon rate that is linked to a reference rate, such as LIBOR or US Treasury bills.
Interest rate hedge
Floating rate notes are designed to rise (or fall) in line with their reference rate. This means there is less price risk. The coupon on a floating rate note is re-set every quarter, to a specified level over the reference rate (eg LIBOR). When interest rates rise, LIBOR in turn ratchets up and consequently, the coupons on floating rate notes increase.
Therefore, they provide a hedge against a rise in interest rates and tend to be in high demand when interest rates are expected to increase. Unlike derivative hedging and structured products, the floating rate note hedge also costs nothing.
Another positive is that they are also very liquid, so when volatility increases in other asset classes, creating miss-pricing, fund managers are able to sell floating rate notes to exploit those opportunities.
The downside is that floating rate notes typically have lower yields than bonds of the same maturities. They also come with similar risks to mainstream government or corporate bonds: namely that a company may not be able to repay the capital at the end of the floating rate note’s term.
Funds that use them to good effect
Nevertheless, at a time when central banks around the world are trying to tighten monetary policy, the broad attractions of this sub-sector have not gone unnoticed.
The Church House Tenax Absolute Return Strategies fund uses floating rate notes to good effect. This multi-asset fund, which invests directly in assets, rather than using the fund of fund route, targets positive returns over rolling 12-month periods and LIBOR +4% over rolling 3-year periods. It currently has almost 30% of the portfolio in floating rate notes.
Co-manager, James Mahon commented: “If rates now rise faster and further than most investors and commentators expect, gilts and corporate bonds will become more volatile – while our allocation of around 30% to floating rate notes will prosper in the Church House Tenax Absolute Return Strategies fund,” he explained.
Likewise, GAM Star Credit Opportunities managers Anthony Smouha and Grégoire Mivelaz have long been fans of floating rate notes.
“These securities will benefit from higher interest rates: the higher the interest rate, the higher the re-fix rate,” they explained.
While they only have a small allocation of 0.5% to floating rate notes directly, they have 43.3% in ‘fixed-to-floater bonds’. These provide a fixed interest for a specified period and then float at a spread over a specified benchmark, which is regularly re-set and can move in line with interest rates.
AXA Sterling Credit Short Duration Bond manager Nicolas Trindade also has an allocation to floating rate notes. He likes that they allow him to add credit risk into the portfolio without taking on duration risk (interest rate sensitivity).
It is worth considering floating rate notes at this point in the cycle. They allow investors to access an income stream which has the potential to rise if interest rates increase. Unlike traditional fixed income, higher coupons are not accompanied by a capital loss.
ATEB Consulting’s Steve Bailey examines why and how Paraplanners should consider a workplace pension in a pension transfer recommendation. Firms involved with...
Fund data and technology company FE fundinfo has acquired cashflow planning provider CashCalc, adding the cashflow planning capability to its suite...
The majority of paraplanners (58%) find suitability report writing software a useful tool but only if used in tandem...