With interest rates rising, fixed rate bonds – those with a set coupon rate until maturity - may be in for a tough time. That’s because rising interest rates reduce the price of fixed rate bonds.
That may sound counter-intuitive, but its all to do with the change in a bond’s yield when interest rates change. It works like a chain reaction: higher interest rates reduce the demand for buyers of bonds, because higher returns are now available elsewhere. The price of that bond falls, increasing its yield.
But a higher yield is a good thing, isn’t it?
Unfortunately, not. The falling price is the major impact, rather than a higher yield. That’s because a yield is just a theoretical measure – it is not received every three months like a coupon. The coupon that the investor receives, meanwhile stays unchanged.
For investors seeking to retain the safety of bond type investments but wanting to help shield again the negative impact of rising interest rates on the capital value of bonds, floating rate notes may prove to be a viable alternative.
What is a floating rate note?
A floating rate note (FRN) is a type of security that is commonly used by banks to fund their lending activities to mainly households or small businesses.
FRNs are a debt obligation like a typical bond. Both represent a contractual requirement for the banks to pay the coupon when they fall due as well as the balance at maturity. In Australia most banks issue FRNs in the 3 to 5 year maturity.
With a FRN, the coupon is floating. Every 90 days the coupon resets at a margin above the Bank Bill Swap Rate (BBSW).
In a rising interest rate environment like we have at the moment, the BBSW is rising because it is effectively pegged to the official cash rate. From one coupon reset to the next, we see the coupons on these bonds rise by a fixed margin to that BBSW rate.
Why do FRN’s have minimal interest rate risk?
A floating coupon rate acts like a stabilizer to take away much of a bond’s duration risk. Duration risk is what adds volatility to a fixed rate bond. The coupon on fixed rate bonds is fixed, and therefore does not change from one payment to the next. It can’t change its coupon rate to act as a stabilizer. But what does change is the market demand for that bond, which also changes the underlying yield.
How does this happen?
When the yield of a bond increases above its coupon, typically the bond falls into a discount. For example, if a bond is issued at ‘PAR’ of $100, it may reprice at $97 due to lower demand from the duration impact (from an increase in interest rates).
Because a floating rate does not have duration risk like a fixed bond, it the FRN’s price rarely moves far away from its PAR level. For example, its PAR may range between $99 to $101, while its coupon may increase as it approaches maturity.
The underlying risk of a FRN, outside of duration risk, is generally the same as the fixed rate bond. Both foxed and floating rate bonds represent contractual obligations from the issuer, so their coupons must be paid to investors before equity investors receive their dividends.
Floating Rate Note | Fixed Rate Bond | |
Does the coupon change? | Has a variable coupon that is reset every 90 days | Has a fixed coupon for the life of the bond |
What happens to coupons in a rising rate environment? | Coupon will continue to rise as interest rates rise | Coupon remains unchanged |
What happens to coupons in a rising rate environment? | Coupon will fall as interest rates decline | Coupon remains unchanged |
What happens to the price of the note or bond as interest rates rise? | As the coupon resets frequently, the duration risk is moderated to very small. Very little change in price. | If the yield increases above its face value (PAR), the bond’s price in the market will fall |
What happens to the price of the note or bond as interest rates fall? | As the coupon resets frequently, the duration risk is moderated to very small. Very little change in price. | If the yield falls to below its face value (PAR), the bond’s price in the market will rise |
What is the difference in credit risk? | Credit risk is the same, from the same issuer | Credit risk is the same, from the same issuer |
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