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 both portfolio protection and consistent returns. Floating rate bonds minimise the impact of rising rates on a bond portfolio. Interest rate risk is almost non-existent and floating rate bonds are typically more capital stable. Citi has 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 and portfolio shelter in time of market stress, while also benefitting from rising rates. However, many investors have not heard of floating rate bonds and therefore have not included them in their portfolio.
Accessing floating rate bonds
Individual floating rate bonds typically are not accessible to many ‘retail’ investors due to regulatory restrictions. At Citi, only ‘wholesale’ investors have access. To be defined as a wholesale investor, a client needs 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.
Certified clients can access products that may be country specific or a multinational corporate giving exposure to a thematic like renewables or communications.
There are a few other ways that investors can access these investment benefits, including via ASX-listed floating rate ETFs and bonds, exchange-traded bonds issued by companies like XTB, and unlisted funds. Listed floating rate bonds provide an option for retail investors but they do not cover the wide range of borrowers available in the unlisted market. Wholesale investors can access traditional floating rate bonds by tapping into a global reach and a larger offering with potentially more attractive yields. Some other brokers allow access to certain bonds in ‘retail’ parcels.
How floating rate bonds work
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 3-month Libor (London Interbank Offered Rate) plus a spread premium. For example, the coupon can be set at 3-month Libor + 2%. At current levels this would mean the investor earns 4.33% which is as compelling as most fixed rate bonds.
Typically, investors cite three main reasons for choosing floating rate bonds:
- Short-term interest rates are expected to rise
- As alternatives to term deposits for higher levels of income
- To avoid the risk in fixed rate bonds of the bond’s price declining when interest rates move up
Recently, purchases of both USD-denominated and AUD-denominated floating rate bonds have increased significantly. Investors are riding the Fed’s rate hiking cycle and are benefiting from expectations of higher short-term rates. The 3-month US Libor is now at its highest since 2008 and some economists expect the US benchmark to near 3.5% by the end of 2019.
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 demand from investors for floating rate bonds has grown, supply has followed with strong creditworthy issuers offering a smorgasbord of choice. Issuances in USD-denominated and AUD-denominated floating rate bonds have increased significantly in 2018.
These two bonds are examples that illustrate this point:
- Barclays PLC issued a 5-year floating rate bond with a current coupon close to 4% that will increase as the Australian benchmark rate, the 90-day BBSW, increases.
- China’s Far East Horizon offers a spread of 2% over the 3-month US Libor for 3 years.
While these two bonds have been the most popular with our 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. This article is for general information only and does not consider the specific circumstances of any individual.