Phil Milburn

FRNs – they’ll be there for you

Phil Milburn

In 2019, the Liontrust Global Fixed Income Team has actively allocated to US dollar-denominated Floating Rate Notes (FRNs). In the Strategic Bond funds the allocation has oscillated in the mid-to-high single digit percentage range. The Liontrust GF Absolute Return Bond Fund focusses on shorter maturity bonds (up to 5-year) and this has naturally led to a much wider range invested in FRNs. The Fund started the year with a weighting in FRNs below 10%, peaked in the summer months around 40% and has been gradually declining since:

Asset allocation - Liontrust GF Absolute Return Bond Fund


FRN coupons vary every quarter depending on where the reference interest rate is, so they have very little duration sensitivity. Furthermore, the majority of FRNs are issued with a 3 to 5-year maturity which is a much shorter average tenor than conventional bonds. This makes them a useful investment option in a market environment in which rates are rising as the FRN coupons reset rapidly to have a yield commensurate with the rate increase.

 

They can also be useful when the bond market has already priced in a lot of rate cuts, as was the case earlier this year. In this scenario, a higher yield can be achieved in FRNs than 2 to 5 year fixed-coupon bonds if the short end of the yield curve has inverted. This was true of the US market in the second and third quarters of 2019, hence why the Liontrust GF Absolute Return Bond Fund had increased its weighting so much earlier this year. Obviously, the coupons on FRNs reduce as interest rates are cut, but a good relative yield boost was achieved as the cuts were neither as deep nor as fast as the market had once priced in.

 

However, we may now scale back the use of FRNs. The Federal Reserve has now signalled a pause to rates – with any future moves dependent on macroeconomic data – and shorter-dated US Treasury yields sitting a small amount higher than the Fed Funds effective rate. If these conditions continue, we envisage slowly reducing the FRN weighting in the funds through a combination of bond maturities and relative value switches into traditional fixed coupon bonds.




What is a Floating Rate Note?

Floating rate notes have been around since the 1970s. The market for FRNs issued by investment grade corporations is over US$500 billion in size. Their name is appropriate; all they are is another type of bond, but one with a variable coupon. 

A standard bond has a maturity date and a fixed coupon that is paid after a regular interval – every year –until the bond matures, hence the generic term “fixed income”. Floating rate notes also have a set maturity date, but the coupon varies every quarter. FRNs are issued with a spread (an additional yield) over a reference rate, such as LIBOR (London Inter-Bank Offered Rate). The spread stays constant throughout the lifetime of the bond, but the reference rate varies. When interest rates are rising, the quarterly coupons on FRNs increase; the converse is obviously true when interest rates are being cut.

Over the last five years, the reference rate in the US has been, on average, about 25 basis points above the Fed Funds effective rate. The UK and eurozone reference rates have been nearer to 10 and 5 basis points higher respectively, when compared to central bank rates. The higher spread in the US boosts the total yield of the FRNs there; it is only a small driver of total returns, but in a low interest rate world every little bit helps.

The biggest concern for investors in FRNs is credit risk. In this regard, credit risk is identical to that in conventional bonds from the same issuer. The FRNs tend to be issued from exactly the same entity with the same seniority as the conventional bonds or, for those that like bond jargon, they rank “pari passu.”  




For a comprehensive list of common financial words and terms, see our glossary 
here.

Key Risks 

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.


Disclaimer

The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.
 

Thursday, November 21, 2019, 3:04 PM