Floating rate bonds



Floating rate bonds (also known as floating rate notes or floaters) are securities which offer interest rates that periodically reset to changes in a representative interest rate index. These securities were created during the volatile bond markets of the 1970's. Floating rate bonds are issued in both the U.S. and international debt markets. At the close of 2010, the US floating bond market was valued at $500 billion. The financial sector is the largest issuer of floating rate debt in the U.S market (see Fig.1.)

Structure
Floating rate bonds possess the following features:
 *  Base index: The interest rate of a floating rate bond is determined by a floating reference rate, such as the prime rate, the fed funds rate, the LIBOR (London Interbank Offered Rate) or other benchmark interest rate.


 * Yield spreads: Yields are usually defined at a certain spread over or under the referenced benchmark index, such as the t-bill rate plus 40 basis points, or the prime rate minus 240 basis points.


 * Reset periods: The reset period determines how often the interest rate will be adjusted. The reset rate may be reset daily, weekly, monthly, quarterly, semiannually or annually, depending on the terms of the bond or the characteristics of the benchmark index.


 * Day count periods: Floating rate bonds count the number of days in an interest payment period by utilizing either a 30/360 convention (assumes 30 day months for a 360 day yearly period), an actual/360 convention (assumes the actual days of each month for 360 day year), or an actual/actual convention (using the actual days in both days and a year). The convention used will be defined by the bond issuer.


 * Payment periods: Interest payments on floaters may be made monthly, quarterly, semiannually or annually.


 * Maturity: Floating rate bonds can be issued at any maturity.

Performance characteristics and risks
According to a Vanguard Research white paper,  A primer on floating rate bond funds , floating rate bonds are subject to three major risk factors. These include interest rate risk, credit risk, and liquidity risk. The paper also examines the correlation of returns with other asset classes; the correlation of returns with inflation; the performance of floating rate bonds during periods of rising interest rates; and the portfolio effects of including floating rate bonds in investment portfolios. The paper measures floating rate bond returns using the Credit Suisse Leveraged Loan Index.

Interest rate risk
Due to the interest rate reset structure of floating rate bonds, the sensitivity of the bonds to interest rate changes is low. Morningstar reports that the average duration of floating rate bond funds is 0.45 years. Floating rate bonds with longer reset periods may be more vulnerable to interest rate and price volatility.

Floating rate bonds are also subject to spread duration Basically, spread duration approximately measures the change in a floating rate bond's price with changes in credit spreads. The price movement will be approximated by multiplying the change in the yield spread times the spread duration. Thus if a floating rate bond has a spread duration of 2.0 and the credit spread widens by 100 basis points, the bond's price will decline by approximately 200 basis points. In May 2011 the duration of the Barclays Capital U.S. Floating Rate (US FRN) Note <5 Years Index was 0.14; the spread duration was 1.8.

Default risk
Floating rate bonds are usually issued by companies that are below investment grade status. The average credit quality of floating rate bond funds is BB - B. Default rates over the 1997 - 2010 period reflect the higher credit risk:

Default Rates:
 * Investment grade bonds 0.1%
 * Senior floating rate loans 3.8%
 * Speculative bonds 4.9%

However most floating rate bonds have senior claims in a company's capital structure, meaning they have the first claims on corporate assets during default. Over the 1997 - 2010 period floating rate bonds had recovery rates of 70.3% during defaults as compared to 35.03% recovery rates for all subordinated debt.

Liquidity risk
Floating rate bonds are unlisted securities. The market is small compared to the broad bond market, and not as liquid. For example, during the 2008 financial crisis, liquidity dried up in the floating rate market, resulting in declines in bond prices and negative total returns.

Asset class correlations
The following table provides return correlations between floating rate bonds (Credit Suisse Leveraged Loan Index) and other asset classes for the 1992 - 2011 period. Floating rate bonds have provided low or negative correlations to treasuries and investment grade bonds. They have the highest correlation with high yield bonds, which is consistent with floating rate bonds having higher credit risk.

Correlations with inflation
Over the 1992 - 2011 period, floating rate bonds have not functioned as a hedge against rising inflation. Analysis in A primer on floating rate bond funds shows that over the measurement period, floating rate bonds had a 0.35 correlation with inflation. Prior to the 2008 financial crisis, the correlation between floating rate bonds and inflation was actually negative: -0.04. The post crisis 0.70 correlation of floating rate bonds to inflation actually reflects widening and retracting credit spreads over the period.

Returns
Since 1992 there have been three periods of rising interest rates in the US bond markets. During these episodes, the Credit Suisse Leveraged Loan Index benchmark has provided premium returns over other fixed income benchmarks of varying durations and credit qualities. However, the index has historically relinquished most, if not all, of the excess return once rates cease rising. The Vanguard study (a primer) finds that the inclusion of floating rate bonds reduced portfolio return over the 1992 - 2011 period. However, for portfolios consisting of 80% or higher bond allocations, the inclusion of floating rate bonds (with 10% - 30% of the bond allocation) reduced portfolio volatility.

Indexes
The most common index of U.S. floating rate bonds used as a benchmark portfolio for floating bond exchange traded funds is the Barclays Capital U.S. Floating Rate Note < 5 years Index. Barclays Capital describes the index thus:

The Barclays Capital U.S. Floating Rate (US FRN) Note <5 Years Index is a subset of the US Floating-Rate Note (FRN) Index, which measures the performance of USD denominated, investment-grade, floating-rate notes across corporate and government-related sectors. This index has a maximum maturity of 4.9999 years and is not part of the US Aggregate Index, which is a fixed coupon index. The index was incepted October 1, 2003.

Other indexes that track floating rate bonds include the Credit Suisse Leveraged Loan Index and the S&P/LSTA Leveraged Loan Index. The Barclays Capital indexes and the proprietary Market Vectors index hold much higher credit quality bonds than do the S&P/LSTA U.S. Leveraged Loan 100 Index or Credit Suisse Leveraged Loan Index. Index return data is provided in Table 2.

Table 2.

Arguments for including floating rate bonds in portfolio asset allocations
iShares argues that floating rate bonds can play the following roles in portfolio allocation:
 * Adjust overall portfolio duration downward.
 * Provide exposure to corporate bonds with reduced interest rate exposure.
 * A diversifier within a traditional fixed income, as well as multi-asset class portfolio.

Vanguard research (August 2011) argues the following investors would benefit from including floating rate bonds in portfolios:
 * Investors who maintain highly bond-centric portfolios (80% or higher bonds).
 * Investors who are adverse to pure interest rate risk.
 * Investors who are not averse to credit risk.

Arguments against including floating rate bonds in portfolio asset allocations
Vanguard research (August 2011) argues that most bond-centric investors are highly risk averse, and that exchanging interest rate risk for higher floating rate note credit risk falls outside these investors risk tolerance. These investors would likely be better served by limiting portfolio volatility by holding short term treasury or short term investment grade bond funds.

Exchange traded funds
Each of the exchange traded funds listed in the table below were introduced in 2010 - 2011, or are currently in registration. One should note that the PowerShares Senior Loan Portfolio holds lower quality bonds (rated Baa - Caa) than do the other three ETF's (rated Aaa - Baa).

Mutual funds
The mutual fund fixed income universe of funds contains a large number of floating rate bond funds, almost all of which are broker-distributed load funds. Morningstar tracks performance of these funds, categorizing them as "bank loan" funds. The average expense ratio for active funds, as reported by Morningstar, is 1.15% per annum.

Floating rate bond funds are also available as closed-end funds. These funds are traded on stock exchanges, often trade at discount or premium to net asset value, often employ leverage, and often utilize managed distribution policies. Most have higher than average expense ratios.

Active funds add to the risks inherent in investing in bond funds by introducing manager risk, the chance that poor security selection or focus on securities in a particular sector or category will cause the fund to underperform relevant benchmarks or other funds with a similar investment objective.