Following 17 consecutive months of a static cash rate, many people have concerns about investing in fixed-rate bonds immediately before a potential rise in rates. Increasingly investors are looking to floating-rate bonds as an alternative.
What are floating rate bonds (FRNs)?
Unlike a fixed-rate bond, which pays a fixed rate of interest, a floating-rate bond has a variable rate that resets periodically. Typically, the rates track the 90-Day Bank Bill Swap Rate (BBSW) which rises (and falls) roughly in-line with official interest rates. FRN coupons are usually based on BBSW plus an added “spread” known as the Initial Margin.
Example of an FRN
- A floating-rate note is issued with a face value of $100 for 3 years with a coupon of ‘3‐month BBSW + a margin, for example 1 per cent’. This means coupon payments will increase if the benchmark 3-month BBSW rate rises, or decrease if it falls.
- 3-month BBSW currently stands at 1.96%, so the rate for this example FRN would be 2.96% in the current coupon period. While the yield changes throughout the life of the security as prevailing interest rates fluctuate, the Initial Margin (the “1%” in the example above) stays the same. Latest BBSW rates can be found here.
- If the price of an FRN is above 100 the investor may get a return less than BBSW + initial margin. If the price is below 100 they may get a return more than BBSW + initial margin.
- For floating-rate bonds the variable coupon has the effect of preserving the capital value of the bond in a rising interest rate environment.
What are the key considerations when deciding if floating-rate bonds are for you?
Available range: Focus on Australian banks
Within the fixed income universe the large majority of non-bank bonds have fixed-rate coupons. There are a number of floating-rate bonds available, however these tend to be issued by Australian banks. There are currently 10 floating rate XTBs, so while fixed-rate bonds offer a much wider selection of issuers, there is still plenty of available choice.
What is your investment timeframe?
Floating-rate bonds have lower volatility than fixed-rate bonds, which may suit short-term investments as an alternative to cash. On the flip-side, for investors intending to hold to maturity and who are happy with the credit risk, fixed-rate bonds may be more attractive as they have longer duration and usually have higher yields.
Floating-rate bonds have similar yields to term deposits*, but have the advantage that they have no minimum holding period. This works well when you don’t know when you will need your cash.
For those looking at shorter term horizons and as an option for some of your cash allocation, floating-rate bond rates compare favourably. Being traded on ASX, XTBs over FRNs allow access to funds on a T+2 basis. If you have funds parked in cash ready to maximise equity buying opportunities, FRNs could provide a better way to optimise these funds.
The crystal ball of when rates will move
If you hold the view that interest rates will move up more quickly than the consensus market view, floating-rate bonds may be worth a closer look. While fixed-rate bonds generally have higher yields, they are designed more as a hold to maturity investment.
Floating-rate bonds largely remove interest rate risk from the mark to market equation. A fixed-rate bondholder can suffer if prevailing interest rates rise, whereas the floating-rate bondholder will receive higher yields if prevailing rates go up. As a result, floating-rate bonds tend to perform better than fixed-rate bonds when interest rates are rising.
The opposite is true if interest rates fall – the floating-rate bondholder will receive lower income if rates fall, because their yield will adjust downward. Also, investors in individual floating rate bonds lack certainty as to the future income stream of their investments. In contrast, an owner of a fixed-rate security knows exactly what he or she will be paid through to the bond’s maturity date.
What is the market view?
We often refer to the chart below for a view on where the market is pricing rate rises. This shows that the market isn’t pricing in a full rate rise until July 2019.
Updated versions of this chart can be found on the ASX website daily.
Comparative rates and added flexibility
The best 3-month TD rate for a top 4 bank is currently 2%². This rate comes with disadvantages of interest being paid at the end of the term and money being locked in for the full term. Savings account rates are generally lower again. They often come with caveats of regular deposits and no withdrawals to meet interest conditions. Having too much of your portfolio sitting in cash can actually compromise wealth. This is because inflation is currently running higher than interest rates on cash products, particularly savings accounts. This results in the value of cash actually falling.
Another challenge for the cash investor is that the banks don’t necessarily pass on rate rises to account holders. This causes additional uncertainty to your portfolio. So even if rates do rise in the near future, will your bank pass on all of this to you?
FRNs are an effective enhancement for cash investments as they potentially offer higher yields than cash. With ‘floating’ coupons which reset every quarter their yield rises with interest rates. Therefore the potential for higher yields comes with an ‘interest‐rate risk’ profile similar to cash and TDs. TDs may enjoy the benefit of protection under the Financial Claims Scheme. Many people actually think of FRNs as being more like cash than they are like fixed-rate bonds.
Regular income benefits
Another benefit of floating-rate bonds is their quarterly coupon cycle, whereas most fixed-rate bonds have bi-annual coupons. Unlike some of the highest yielding TDs and Cash Management Accounts, which only apply interest at the end of the savings period, investing in floating-rate bonds allows you to determine your own cycle of interest payments.
The XTB Monthly Income Portfolio contains just 3 floating-rate XTBs, but offers holders a regular monthly income as bonds have been selected to pay coupons in each month of the year.
Ready to look closer at floating-rate bonds?
If you’re ready to make the next step and look further at including floating-rate bonds within your portfolio, the next questions to consider are:
- How can you invest in floating-rate bonds?
- How do the options available compare in terms of performance and fees?
1. Investment options for floating-rate bonds
Investing directly in floating-rate bonds has traditionally been difficult. As with all bonds, FRNs are usually only accessible to institutional investors, where they are traded off‐market and often require a large minimum investment size.
More recently, a number of floating-rate ETFs have become available and XTBs have opened up access to individual floating-rate bonds. Selecting individual XTBs gives greater control over portfolio outcomes – investors can select from the 10 available floating-rate XTBs, or choose to invest in the XTB Monthly Income portfolio.
2. Performance & fees
The 12-month performance of the XTB Monthly Income Portfolio at 31 Dec 2017 was 3.6% p.a. This compares to Betashares AAA ETF at 2.1% p.a.³. Being traded on ASX, both XTBs and ETFs will be subject to broker fees to buy and sell.
The XTB fee for floating-rate bonds is 0.20% of the Face Value times the number of years to maturity. This compares favourably with buying bonds over the counter, where custody fees are often set around this level.
² Canstar best available 3-6 month TD rate from a top 4 bank. TDs also enjoy the benefit of the $250,000 government guarantee, making TDs less risky than FRNs
³ XTB and Bloomberg
* Term Deposits may enjoy the benefit of protection under the Financial Claims Scheme.