Floating rate notes: four questions answered

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.

What is a floating rate note?

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%.

Why would you buy a floating rate note?

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.

Who issues floating rate notes?

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.

How long are they issued for and how often do they pay?

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.

This article is provided for information only. The views of the author and any people quoted are their own and do not constitute financial advice. The content is not intended to be a personal recommendation to buy or sell any fund or trust, or to adopt a particular investment strategy. However, the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions. Past performance is not a reliable guide to future returns. Market and exchange-rate movements may cause the value of investments to go down as well as up. Yields will fluctuate and so income from investments is variable and not guaranteed. You may not get back the amount originally invested. Tax treatment depends of your individual circumstances and may be subject to change in the future. If you are unsure about the suitability of any investment you should seek professional advice. Whilst FundCalibre provides product information, guidance and fund research we cannot know which of these products or funds, if any, are suitable for your particular circumstances and must leave that judgement to you. Before you make any investment decision, make sure you’re comfortable and fully understand the risks. Further information can be found on Elite Rated funds by simply clicking on the name highlighted in the article.