144. Why confusion over conviction will lead to bouts of volatility
Church House Tenax Absolute Return Strategies co-manager James Mahon tells us why low bond prices...
In a world where cash returns very little, bond yields are very low or even negative and price risk (the risk an asset will fall in value) is a problem, floating rate notes may be a useful alternative. While it’s hard to buy these as an individual investor, you can gain exposure through Elite Rated funds like Church House Tenax Absolute Return Strategies and GAM Star Credit Opportunities.
Floating rate notes sit in a category rather awkwardly labelled as ‘near-cash instruments’. In reality, though, they are closer to bonds. They usually pay a variable—or floating—coupon rate that is linked to a reference rate such as LIBOR or US Treasury bills, in addition to a fixed spread. The spread is expressed in basis points above the reference rate.
So, for example, a floating rate note might be linked to GBP LIBOR 6-month rate, plus a spread of 50 basis points. If the LIBOR rate is 0.57%, this would make the note’s total coupon 1.07%. As the GBP LIBOR 6-month rate shifts, the coupon rate of the note is re-calculated. So if the LIBOR reference falls to 0.4%, the coupon rate will fall to 0.9%; if the LIBOR reference rises to 0.7%, the coupon rate will rise to 1.2%.
Floating rate notes are often popular in periods of low interest rates and especially when people think interest rates are going to rise. This is because when you buy a bond, you lock in a coupon rate. So if you buy in a low-rate environment, you will be stuck with that coupon even when interest rates start to rise. A floating rate note’s coupon, however, is designed to rise (or fall) in line with its reference rate.
This also means there is less price risk – bonds will fall in value as the difference between their coupon and interest rates increases, but floating rate notes’ prices should not be affected by interest rate movements. It is worth noting that because they have this attribute, floating rate notes typically have lower yields than bonds of the same maturities.
Like bonds, floating rate notes can be issued by governments or corporations. In the case of corporations, typically financials. It’s worth keeping in mind, therefore, that even though they are called ‘cash-like’ and are thought of as a conservative investment, there can be company/credit risk. Meaning that just as with a bond, there is the risk the company may not be able to re-pay your capital at the end of the floating rate note’s term.
This varies between notes, but they will typically have shorter dates to maturity than bonds. For example, a floating rate note may be issued for three months, six months or a year. Or it may be slightly longer, but usually no more than 10 years. Payout frequencies likewise may vary, but could be quarterly, twice-yearly or annually. The coupon rate will either be calculated once per payment period, or calculated daily and then paid out as an average of each day’s rate over that period.