Floating rate bonds skyrocket in popularity

Today’s market poses a conundrum for bond investors. On the one hand, volatility stemming from rising trade tensions, and China’s slowing growth are driving investors towards bonds as a traditional portfolio shelter. On the other hand, central banks around the world are tightening policy and conventional investment wisdom dictates that bonds do not perform well in a rising rate environment.

What many investors are missing out on is the fact that floating rate bonds allow you to both protect your portfolio and get consistent returns.

Across Australia, investors have been reducing the interest rate risk of their global portfolios, the risk of a bond’s price declining when interest rates move up. Floating rate notes are a great opportunity to minimise the impact of rising rates on a bond portfolio. As per their inherent structure, interest rate risk is almost non-existent. Citi has also seen a five-fold increase in year-to-date investment in floating rate bonds by investors, compared to the same period over 2017. 

Investors are attracted to this asset class as floating rate bonds offer investors the inherent advantages of bonds such as regular income, portfolio shelter in time of market stress, while also benefitting from rising rates. However, there are many investors who simply haven’t heard of floating rate bonds and therefore have not included them in their portfolio. 

Floating rate bonds typically are not accessible to retail investors due to regulatory restrictions. At Citi, only wholesale investors can get access to floating rate bonds via their relationship manager. To be defined as a wholesale investor, a client needs to have a qualified accountant’s certificate stating they have net assets of at least $2.5 million, or a gross income for each of the last two financial years of at least $250,000. 

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Certified clients use our global network to access product where they want it – for example it may be country-specific or a multinational corporate to get exposure to a thematic like renewables or communications. Few local players can offer clients that global footprint. 

For those unfamiliar, floating rate bonds pay a coupon that resets periodically and is based on a benchmark short-term interest rate index. For USD bonds the regular coupon paid to investors is typically the three-month Libor (London Interbank Offered Rate) plus a spread premium. For example, the coupon can be set at three-month Libor + two per cent. At current levels this would mean the investor earns 4.33 per cent which is as compelling as most other fixed bonds. 

Typically, investors cite three main reasons for choosing floating rate bonds: 

1. Floating rate bonds make the most sense when short-term interest rates are expected to rise;
2. They are attractive investment alternatives for deposit investors constantly looking for higher levels of income from interest rate increases; and
3. Compared to fixed rate bonds, the risk of a bond’s price declining when interest rates move up, called the interest rate risk, is almost non-existent. This means floating rate bonds are typically more capital stable. 

Recently, purchases of both USD-denominated and AUD-denominated floating rate bonds have increased significantly. Our investors are riding the Fed’s rate hiking cycle and are benefiting from expectations of higher short-term rates. The three-month US Libor is now at its highest since 2008 and Citi economists expect the US benchmark to near 3.5 per cent by the end of 2019 as the Fed continues to raise its policy rate. 

Domestically, even though the RBA currently remains on-hold, our economists consider the central bank maintains the view that the next move in interest rates is likely to be up. As short-term interest rates are usually correlated to policy rates, AUD-based investors would then benefit from exposure to floating rate bonds.

As demand from investors for floating rate bonds has grown, supply has also followed suit with strong creditworthy issuers offering a smorgasbord of choice. 

Issuances in USD-denominated and AUD-denominated floating rate bonds have also increased significantly in 2018. Recent AUD-denominated issuances from leading international corporates and financials have included floating-rate tranches, offering investors attractive spreads over the benchmark rate.  

These two bonds are examples that illustrate this point:

1. Barclays PLC has come to the market with a five-year floating rate bond with a current coupon close to four per cent, that will increase as the Australian benchmark rate, the 90-day BBSW, increases. 
2. China’s Far East Horizon offers a spread of two per cent over the three-month US Libor for three years. Should the 3-month US Libor near 3.5 per cent, this could be a coupon of around 5.5 per cent at the reset period, a rate that is significantly above any term-deposit rates and for a risk lower than equity investments. 

While these two bonds have been the most popular with Citi clients in 2018 to-date, each customer should consider their own needs and circumstances before deciding to invest. 

With the market having priced one more Fed hike for 2018 and with the growing likelihood of a second one, investors look likely to continue turning to floating rate notes for both portfolio protection and consistent returns.  

Elsa Ouattara is a fixed income strategist at Citi Australia.