In recent years we have seen unprecedented actions by global central banks to influence economic events and create monetary stimulus. Here in the Unites States, the Federal Reserve has held interest rates well below historical norms through both conventional and unconventional methods. There can be a number of unintended consequences with any actions that distort markets.
One such consequence is those living on fixed income or positioning a portion of their investments in fixed-income assets are receiving significantly lower yields on their invested assets. Many investors are left searching for different solutions to offset this lack of cash flow, and are often pushed into asset classes which are more aggressive and risky than something they might ordinarily purchase. As of May 2016, the 10-year US Treasury continues to hover in a trading range below 2%. This has created some opportunities in the market for floating-rate securities in recent years.
Floating Rate Notes are secured bank loans made to non-investment grade companies. Ordinarily, anything below investment grade would simply be characterized as “High Yield Bonds, Junk Debt or Junk Bonds”. Yet, there are some significant differences between traditional High Yield Bonds vs Floating-Rate Notes. High Yield Bonds can serve as a hedge against a rising interest rate environment, as they tend to move with the stock market and look more attractive in a strengthening economic environment. When rates are falling, High Yield tends to decline, as their anticipated default risk rises in a weakening economic environment. While this tends to be somewhat true with Floating Rate Notes, they are quite a bit different in terms of risk. With Floating Rate Notes, banks loan money to these below investment grade companies…but secure the loan with collateral in the company. They are issued as senior debt in the capital structure. That means in the event of a restructuring, the holder of these notes would be paid off first as they take priority over other debt holders.
A typical High Yield bond is issued with a maturity of 10 years, whereas the average maturity of a Floating Rate Note at issuance is five to seven years. Since the Floating Rate Notes are callable, they have an actual average maturity of less than three years. This is because the payment is usually compromised of some amortization and required payments from the borrower’s excess cash flow. In the current interest rate environment the shorter maturities may look attractive to a number of investors who are concerned about the negative impact on fixed-income from rising rates, should that ever occur.
Floating Rate Notes are also “Floating” as implied in the name. This means that as rates rise, the issue itself begins to pay a higher interest payment, unlike a traditional High Yield Bond which is issued with a fixed rate. The reason for this is that they are bank loans. They are offered with a spread over the London Interbank Offered Rate, also known as LIBOR. So as rates rise…the LIBOR plus the spread increasing…this will increase the rate of payment. This offers an investor an additional hedge against rising rates.