Floaters Sink Rising Hopes

In the course of my business, I speak with many financial advisers. By and large they are responsible people who try to to what is best for their clients. However, when it comes to product knowledged and knowledge of the capital markets, some are not much more knowledgeable than the clients they advise.

One of the most misunderstood products is the floating rate bond. Simply stated, a floating rate bond has a coupn which adjusts, or floats, off a a benchmark. Benchmarks can include LIBOR the Constant Maturity Treasury or a measure of inflation. Investors and financial advisers like these bonds because they believe (assume) that a floating coupon will result in a bond trading at or nea par regardless of market condtions. Nothing could be further from the truth.


In theory, if a bond's coupon would be linked to a benchmark which had a similar maturity as the bond itself, the bond could trade in a fairly narrow range. This would be more true of an interest rate product such as a government bond. All other bonds are credit products and are influenced by changes to the issuers perceived creditworthiness. This is expressed by the credit spread (the number of basis points above a similar U.S. treaury investors will receive in terms of yield for taking on the credit risk of a corporate bond or agency. Widening credit spreads could cause prices to fall (or at least not rise when treasury prices are rising) or vice versa.


Another factor comes into play. This is optionality. All adjustable and optional features are there to benefit the issuer, not the investor. It is common to see a long-term floating rate security adjust is coupon versus a short-term benchmark. When yield curves are steep, credit spreads aside, prices of floaters could be at significant discounts. Why? If a bond spreads ist coupon 100 basis points over 3-month LIBOR and thre month LIBOR is at 4.50%. The bond will have a coupon of 5.50%. However, let's say the bond matures in 30 years and thirty year bonds from that issuer are trading at 7.00%. The floating rate bond would have to trade at a similar yield.

Many of you may be saying: "When the yield curve is flat, floaters can trade at par or even a premium. This is true, but the upside is usually limited by a call feature. The possibility of an issue being called limits its upside. Since the downside potential is greater than the upside potential, callable bonds are said to be negatively convexed.

How are these features more beneficial to the issuer than to the investors? An issuer issues a floater because it believes that it will pay a lower average coupon than if it comes with a fixed rate for that maturity. What if it is wrong? Here is where the call feature comes into play.

At the time a bond becomes callable, if the issuer can refinance the bond at a lower rate, it will call the bond. If it can't, the bond will remain outstanding. The lesson here is that bond option features are there to benefit the issuer.

Investors looking for income and less volatility should consider high-coupon / short-duration high-quality bonds. Duration should not be confused with maturity. Simply stated, duration is the weighted average life of a bonds cashflows (higher the coupon, lower duration). This is a simple explanation of duration. There are several other measures of duration, but that is a discussion for another day.