Floating-Rate Notes: 3 Things to Consider

January 25, 2022 Collin Martin
If the Federal Reserve hikes rates, investment-grade floating-rate note yields may rise. There are pros and cons to investing in floaters, however, and performance relative to fixed-rate corporate bonds can vary.

With the Federal Reserve likely to begin raising its target short-term interest rate as soon as its March meeting, we believe investment-grade floating-rate notes are worth consideration today.

As the federal funds rate rises or falls, floater coupon rates tend to follow, and their prices aren't overly sensitive to fluctuating interest rates. 

There are pros and cons to investing in floaters, however, and performance relative to fixed-rate corporate bonds can vary. While they are certainly worth consideration today, it's important to understand their various nuances, and to pay attention to the outlook for Federal Reserve policy, as the pace and magnitude of rate hikes can play an important role in floating-rate note performance.

The basics of floaters

Investment-grade floating-rate notes, commonly referred to as "floaters," are a type of corporate bond investment whose coupon rates are tied to a short-term benchmark rate. A measure of additional yield is usually added to the reference rate to compensate investors for the risks of lending to a corporation, such as the potential that it will default and fail to make timely payments on its debt. Because these are issued by investment-grade-rated corporations, the "spread" between the reference rate and the floating-rate note yield tends to be relatively low, usually in the 25- to 100-basis-point range.1

The underlying reference rates for floaters can vary these days. Historically, floaters were referenced to the three-month London Interbank Offered Rate (LIBOR) but that rate is in the process of being retired. Many recent floater issues use the Secured Overnight Financing Rate (SOFR) as the reference rate. 

Any way you slice it, the underlying reference rates are short-term rates and tend to have a strong relationship with the federal funds rate.

Floater coupon rates tend to follow the lead of the federal funds rate

Since 2004, the Bloomberg U.S. Floating-Rate Note Index average coupon rate has followed the trend of the federal funds target rate. For example, between 2004 and 2006 both rates rose from about 1% to above 5% as the Federal Reserve hiked rates. The Fed then began cutting rates during the 2007-2008 financial crisis. By 2009 the federal funds rate was near zero and the floating-rate note index average coupon was below 1%.

Source: Bloomberg, using weekly data as of 1/21/2022.

Bloomberg U.S. Floating Rate Note Index (BFRNTRUU Index) and U.S. Federal Funds Target Rate Mid Point of Range (FDTRMID). Past performance is no guarantee of future results.

Floaters are attractive in a rising-interest-rate environment because their prices are not very sensitive to changing interest rates. Their coupon rate adjusts to shifts in short-term interest rates, so their prices don't need to. That results in more stable prices regardless of what Treasury yields are doing. However, floater prices can fluctuate due to credit concerns. If the economic outlook deteriorates, floater prices can fall if corporations' ability to service their debts declines.

Three things to consider with floaters

The prospect of rising short-term interest rates doesn't necessarily mean that floaters are the right investment for all investors. There are pros and cons to investing in floaters, and their performance compared to fixed-rated corporate bonds has been mixed during previous Fed rate-hike cycles. Here are three things to consider before adding investment-grade floaters to your portfolio:

1. Floater yields are lower than fixed-rate corporate bond yields

The bond market tends to be forward-looking. When market participants expect the Fed to start hiking rates, many bond yields will rise in anticipation. For example, the 2-year Treasury yield rose above 1% in mid-January for the first time since before the pandemic began. Meanwhile, the 3-month Treasury bill yield was anchored at roughly 0.15%. One- to five-year fixed-rate corporate bond yields have risen due to this dynamic with Treasury yields, while floater yields remain stubbornly low. Keep in mind that floater coupon yields should rise once the Fed begins to hike rates, but it will take a number of hikes before the average yield catches up to the yield-to-worst2 of the fixed-rate index. If you're looking for higher income payments today—rather than waiting for the Fed to hike rates—short-term corporate bonds might make more sense. As the chart below illustrates, it would take roughly five Fed rate hikes for the yield of the floater index to catch the yield of the Bloomberg U.S. Corporate 1-5 Year Bond Index.

Floater yields are well below short-term, fixed-rate corporate bond yields today

As of January 21, 2022, the yield of the Bloomberg U.S. Floating-Rate Notes Index was 0.4% while the yield of the Bloomberg U.S. Corporate 1-5 Year Bond index was 1.8%. Since 2012, the floating-rate index yield has usually been lower than the yield on the 1-5 year corporate bond index.

Source: Bloomberg, using weekly data as of 1/21/2022.

Bloomberg U.S. Floating Rate Note Index (BFRNTRUU Index) and Bloomberg U.S. Corporate 1-5 Year Bond Index (LDC5TRUU Index). Yield-to-worst is the lower of the yield-to-call or yield-to-maturity. It's the lowest potential rate of return for a bond, absent a default. Past performance is no guarantee of future results.

2. Floater prices tend to be very stable

This is a key benefit for investors, especially for those who are worried about the effect of rising interest rates on their bond holdings.

The prices and yields of fixed-rate bonds have an inverse relationship. If a fixed-rate bond's yield rises, its price falls (and vice versa). If market interest rates rise, a low fixed coupon rate may no longer be attractive—the price will generally fall to make its yield more in line with market interest rates.

That's not the case with floaters. Because their coupons adjust with market interest rates, their prices don't need to. Over time, floater prices tend to be very stable, whether the Fed is raising or lowering interest rates. Keep in mind that floaters can help mitigate interest rate risk, but they still have credit risk, like the risk of default. If credit conditions deteriorate and the creditworthiness of corporate bond issuers declines, floater prices can fall just like the prices of fixed-rate bonds. Sector concentration is another risk. Bonds from the financial institutions sector make up 58% of the Bloomberg U.S. Floating-Rate Notes Index, meaning it's difficult to get much sector diversification and the market could be sensitive to periods of financial stress. 

The chart below illustrates these risks, as floater prices fell during the 2008-2009 financial crisis, the 2011 European debt crisis, and in the early days of the 2020 pandemic.  

Floater prices tend to be much more stable than fixed-rate bond prices

Since 2003, the average price of the Bloomberg U.S. Floating-Rate Notes Index has tended to be more stable than the Bloomberg U.S. Corporate 1-5 Year Bond Index. However, floater prices fell sharply during the 2008-2009 financial crisis, during the 2011 European debt crisis, and in the early days of the 2020 pandemic.

Source: Bloomberg, using weekly data as of 1/21/2022.

Bloomberg U.S. Floating Rate Note Index (BFRNTRUU Index) and Bloomberg U.S. Corporate 1-5 Year Bond Index (LDC5TRUU Index). Past performance is no guarantee of future results.

3. Performance varies

The pace and number of rate hikes tend to influence how floaters perform relative to short-term, fixed-rate corporate bonds. During the 2004-2006 rate-hike cycle, floaters significantly outperformed as the Fed hiked rates a total of 17 times, raising its target rate from 1% in June 2004 all the way to 5.25% by June 2006. Not only did floaters outperform their fixed-rate counterparts, but they also experienced a lot less volatility.

Floaters outperformed during the 2004-2006 rate hike cycle, with little volatility

From June 2004 to June 2006, floaters' total return climbed steadily, reaching 7.2% by June 2006. During the same time period, short-term, fixed-rate corporate bonds total return increased to 4.5%, with more volatility.

Source: Bloomberg. Total returns from 6/25/2004 through 6/30/2006.

Bloomberg U.S. Corporate 1-5 Year Bond Index (LDC5TRUU Index) and Bloomberg U.S. Floating Rate Notes Index (BFRNTRUU Index). Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no guarantee of future results.

Fast-forward to 2015, and the performance numbers are not as impressive. Over the three-year rate-hike cycle, floaters only modestly outperformed short-term, fixed-rate corporate bonds, but much of that outperformance came at the end of the rate-hike cycle. For the first two years of the rate-hike cycle, floater performance lagged as the Fed took a very patient approach to rate hikes. The Fed raised its target rate by 25 basis points in December 2015, and then waited a full year to hike rates again. When all was said and done, the Fed hiked rates a total of nine times over three full years, compared to 17 times over just two years in the previous cycle.

Floaters eventually outperformed fixed-rated corporates during the last cycle, also will little volatility

From December 2015 to December 2018, the cumulative total return of the Bloomberg U.S. Floating-Rate Note Index rose to 5.9%. The cumulative total return of the Bloomberg U.S. Corporate 1-5 Year Bond Index rose to 5.6%, with more volatility.

Source: Bloomberg. Total returns from 12/11/2015 through 12/21/2018.

Bloomberg U.S. Corporate 1-5 Year Bond Index (LDC5TRUU Index) and Bloomberg U.S. Floating Rate Notes Index (BFRNTRUU Index). Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no guarantee of future results.

As we approach the beginning of the next Fed rate hike cycle, the pace and number of rate hikes will play a large role in the performance of floaters. If the Fed hikes too quickly and the economic outlook deteriorates as a result, it might not be able to even get to a 2% federal funds rate. In that scenario, floaters could underperform, as their income payments might not rise enough to make up the difference that fixed-rate corporate bonds provide today.

However, if the Fed takes a more patient approach to rate hikes—enough to slow inflation but not enough to derail the strong economic momentum—then it may be able to successfully increase the federal funds rate above the 2% level (or potentially even higher), in which case floaters may outperform as their coupon payments continue to grow.

What to consider now

Investment-grade floaters can make sense as the Fed begins to hike rates. While performance has been mixed compared to fixed-rate corporate bonds during previous rate hike cycles, their low interest rate sensitivity may make them more attractive for investors worried about the risk of rising rates on their bond holdings. Floaters can allow you to stay invested in the bond market, rewarding investors with higher income payments as the Fed hikes rates, rather than trying to time the market and waiting for the "right" time to invest in bonds.

One way to get direct exposure is through an exchange-traded fund (ETF) that tracks a floater index. Unfortunately there isn't a specific Morningstar category for investment-grade floating rate notes, but there is a way to screen for funds using the ETF screener. First start with "Taxable Bond" as the Fund Category, and then under Morningstar Category, select "Ultrashort bond." Finally, on the left side of the screen, select "Fund Name" and include "float" as a descriptor. Using those criteria should provide some ETFs that focus on investment-grade floaters, but keep in mind that might not be the comprehensive list.

1 One basis point is equal to 1/100th of one percent, or 0.01%, or 0.0001. Thus 50 basis points is equal to 0.5% and 100 basis points is equal to 1%.

2 Yield-to-worst is the lower of the yield-to-call or yield-to-maturity. It's the lowest potential rate of return for a bond, absent a default.

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