Following the spread of the Covid-19 pandemic, central banks globally acted swiftly to ease financial conditions, cutting interest rates where possible and injecting significant amounts of liquidity into the system. As shorter-dated interest rates fell, so too did medium- and longer-term interest rates. Today, rates across the entire curve remain exceptionally low, or negative in some jurisdictions.
Standard investment-grade bonds, in other words those issued with fixed coupons, have two components to their yield. The first is the compensation for interest rate risk which is determined by the prevailing government bond yield. The company issuing the bond has no influence over this level as it is defined by local central bank policy, fiscal policy, inflation expectations etc. The second is the compensation for credit risk, determined by the credit spread of the specific company. The company can affect this in that if they have a robust balance sheet, solid earnings and future growth potential, they will likely be rewarded with a smaller credit spread than if the opposite were true. Interest rates today are at their effective lower bound and as a result, credit investors in standard corporate bonds receive little or negative compensation for taking interest rate risk, with the entire yield from the bond effectively coming from the compensation for credit risk.
Floating-rate notes (FRNs) are bonds issued with variable interest rates.
At successive intervals, typically quarterly, the interest rate is reset based upon a predetermined benchmark rate, such as Libor currently. This means that if the benchmark rate moves up, the interest rate on the FRN will increase and if the benchmark rate moves down, the interest rate on the FRN will follow. Given the frequency of resets, the interest rate risk on these bonds is essentially zero. FRNs are issued by governments, agencies and also corporates.
Why is this important today? As mentioned, interest rates are at their effective lower bound and global central banks have been clear that they do not wish to cut rates further, preferring to use other monetary stimulus measures such as quantitative easing to prime markets and prevent dislocations.
On the other side of the coin, the next significant move in interest rates could be upwards for a myriad of reasons, including heavy bond supply as a consequence of the current fiscal stimulus, or an unwind of the risk-off buying of safe-haven government bonds we have seen for the past few months, especially in the event of an effective Covid vaccine. Such moves would lead to capital losses for fixed-coupon bonds but have limited or no impact on FRNs.
Further, one potential tail risk for fixed income investors is future sustained inflation. Although absent for a prolonged period of time, excess inflation, should it return, would likely force central banks to tighten policy sooner than expected. For instance, current market pricing for the next interest rate hike from the Federal Reserve is not until mid-2024 and from the ECB in late-2025. If central banks did need to raise rates to prevent excessive inflation, the variable coupon on the FRN would also increase, benefitting the investors in this asset class.
For the reasons outlined above, we believe FRNs offer an attractive opportunity for a variety of investor types over the medium term. For those looking purely for credit exposure without the interest rate risk, FRNs are the most efficient tool to achieve this. For investors with existing investment-grade exposure, adding investment-grade FRNs or an FRN fund would lower their overall interest rate risk whilst maintaining credit exposure. This would optimise the risk/reward pay-off given rates are at the effective lower bound and unlikely to fall further, and central banks will continue to support credit markets. For investors that fear unexpected and sustained increases in inflation leading to an increase in central bank rates earlier than currently anticipated, FRNs would respond favourably as the increase in the central bank rate would be reflected in the subsequent coupon reset on the FRN. Finally, given rates globally are now so low, for those investors looking to earn income in excess of cash levels but in a relatively risk-averse manner, investment-grade FRNs offer a yield pick-up, limited credit risk and no interest rate risk.
Christel Rendu de Lint
Head of Fixed Income
Senior Fixed Income Investment Specialist