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Fixed Income Investing – Part VI Floating Rate Notes BMO Wealth Management Fixed Income Investing – Part VI Floating Rate Notes Traditional fixed income investors long for steady income and preservation of capital. However, with rising interest rates, many have seen the price of their fixed-rate bonds come under pressure recently. While fixed-rate bonds lose value when rates increase, with Floating Rate Notes (“FRNs”) the coupon rate adjusts higher with market rates, providing some principal protection. This article delves into the Canadian Floating Rate Note market and reviews how FRNs may supplement a diversified fixed income portfolio. Basics of Floating Rate Notes This floating rate feature allows the bond to reset its future Typically speaking, when interest rates go up, fixed-rate bond cash flows to match the higher return expected by the prices go down. This is because the market will revalue the market. The higher cash flows relieve the downward pressure bond based on the new higher rate – and since the coupon on the price of the bond from a rate increase, giving FRNs itself is a fixed payment, the bond price must give. With FRNs, stronger principal protection. Conversely, in a falling rate when rates go up, so do the coupon payments. The floating environment, FRNs will return decreasing interest payments, rate coupon adjusts periodically (typically every three months) so their performance will lag that of a similar fixed-rate at a fixed spread over a pre-determined benchmark, which is bond. (See Figure 2.) considered a proxy for short-term, risk-free exposure. There Figure 2: Impact of Different Rate Environments are two components to the overall coupon rate of an FRN: the Interest Rate Floating Rate Note Fixed Rate Note variable reference rate and the fixed spread. (SeeFigure 1.) Direction Price Cashflow Price Cashflow Figure 1: Components of a Floating Rate Note Coupon Increase Higher Demand = Up Down No Change Higher Prices Period 1 Decrease Lower Demand = Down Up No Change Lower Prices Coupon Rate 2.10% Source: BMO Capital Markets 2% Fixed Spread 0.35% Due to these periodic resets, the interest rate sensitivity of FRNs, as measured by duration, is even lower than their maturities would imply. Because the coupon payment frequently changes, the duration is effectively the same length 1% of time as the next coupon reset date. For example, a newly Variable Reference Rate 1.75% issued three-year FRN that resets its coupon every three months has a duration of 0.25. The duration will decrease toward zero as the three-month period passes, at which point the interest rate paid by the FRN will be reset, and the duration will jump back up to 0.25, as the cycle begins anew. 0% CONTINUED BMO Wealth Management Fixed Income Investing – Part VI Floating Rate Notes PAGE 2 In Canada, the benchmark reference rate most commonly The Canada Housing Trust is a special-purpose entity set up used is the Canada Dollar Offered Rate (“CDOR”)1, while to issue bonds backed by residential mortgages insured with the U.S. Dollar London InterBank Offered Rate (“LIBOR”) is the Canadian Mortgage and Housing Corporation. They are typically used for U.S. dollar-denominated FRNs. These rates the largest issuer of FRNs in Canada, and come with a federal are set daily. (See Figure 3.) guarantee. Due to its AAA-rating, investor demand is strong. Figure 3: CDOR and LIBOR Three-month Rates Not surprisingly, given their size, Ontario and Quebec make up 60% of FRNs issued in the provincial sector. However, in 5 the context of all bonds issued by the provinces, the floating rate structure is quite small, at around 3% of outstanding 4 issues, with their preferred supply coming in the form of 3 fixed-rate bonds. 2 Banks are relatively agnostic to the issuance of floating 1 or fixed-rate securities, as they actively use derivatives to 0 hedge between fixed and floating liabilities. Given investor demand typically favours fixed-rate bonds, only around 15% of outstanding bank bonds are FRNs. USD 3 Month LIBOR 3 Month CDOR Issuance trends 1 The Canada Dollar Offered Rate (“CDOR”) is the rate at which Canadian banks would be willing to lend funds for specific terms-to-maturity to institutional clients. Other Since the 2008 financial crisis the issuance of FRNs picked benchmarks may also be used, so it’s important to know which benchmark rate is being used for the FRNs you own. up, especially in the Financial sector, as investors once again became comfortable taking on credit risk. There does The Floating Rate Note market appear to be a positive correlation between FRN issuance and expectations of interest rate increases. This intuitively The Floating Rate Note market in Canada is relatively small makes sense given that demand will be stimulated in a rising and dominated by a handful of issuers. The vast majority of rate environment as floating rate notes would continually FRNs are issued with maturities under three years, which is increase their payment streams. (See .) very short when compared to the average term of 10 years for Figure 5 the FTSE-TMX Bond Index. With an outstanding market value Figure 5: Floating Rate Notes Issued in Canada of $125 billion, the FRN market makes up just over 5% of the 60 total Canadian dollar-denominated investment grade bond market. Figure 4 shows that almost 90% of all FRNs are issued 50 by the Canada Housing Trust (“CHT”), provinces, and banks. 40 Figure 4: Canadian Floating Rate Note Market by Sector 30 $ Billion All Canadian Dollar FRNs 20 Other 10 Corps 12.36% 0 CHT 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 YTD 30.93% CHT Provincial Bank / Credit Union Other Source: Bloomberg Banks Note: As of May 16, 2018 27.66% Provincial 29.06% Source: Bloomberg Note: As of May 16, 2018. Excludes <$100M CONTINUED BMO Wealth Management Fixed Income Investing – Part VI Floating Rate Notes PAGE 3 Why buy Floating Rate Notes? Exchange-traded Funds Investors should include FRNs in their portfolio for principal As the Canadian FRN market is small and, at times, less liquid protection and diversification. As Floating Rate Notes will trade than the market for fixed-rate bonds, Exchange-traded Funds at – or near – its par value regardless of the rate environment, (“ETFs”) can be an easier way to gain exposure to Floating barring any credit concerns, they can be attractive when Rate Notes. However, it’s important to be cognizant of how reduced volatility is the most important consideration. Given this floating rate exposure is created. Not only should attention that FRN price performance has a relatively low correlation be paid to what the ETF is aiming to replicate in terms of credit with interest rates, they also offer diversification benefits to exposure, but also how that floating rate structure is achieved. fixed income portfolios. Some ETFs simply buy a basket of actual FRNs to mimic their For investors with a strong view on the direction of short- benchmarks, whereas others may use fixed-rate bonds, where term interest rates, they can tactically use FRNs within liquidity is greater, and use derivatives to manage duration their overall fixed income allocation. If they expect short- exposure and synthesize floating rate returns. term rates to increase, the coupon on the securities should Please speak to your BMO Nesbitt Burns Investment increase commensurately, resulting in outperformance versus Advisor if you have any questions about this article fixed-rate equivalents. Similarly, if an investor anticipates the ! or would like to discuss the fixed income component reference rate to decrease, they would look to shift out of a of your portfolio. floating rate security and move into a fixed-rate security. BMO Wealth Management provides this publication for informational purposes only and it is not and should not be construed as professional advice to any individual. The information contained in this publication is based on material believed to be reliable at the time of publication, but BMO Wealth Management cannot guarantee the information is accurate or complete. Individuals should contact their BMO representative for professional advice regarding their personal circumstances and/or financial position. The comments included in this publication are not intended to be a definitive analysis of tax applicability or trust and estates law. The comments are general in nature and professional advice regarding an individual’s particular tax position should be obtained in respect of any person’s specific circumstances. BMO Wealth Management is a brand name that refers to Bank of Montreal and certain of its affiliates in providing wealth management products and services. Not all products and services are offered by all legal entities within BMO Wealth Management. BMO Private Banking is part of BMO Wealth Management. Banking services are offered through Bank of Montreal. Investment management services are offered through BMO Private Investment Counsel Inc., an indirect subsidiary of Bank of Montreal. Estate, trust, planning and custodial services are offered through BMO Trust Company, a wholly owned subsidiary of Bank of Montreal. BMO Nesbitt Burns Inc. provides comprehensive investment services and is a wholly owned subsidiary of Bank of Montreal. If you are already a client of BMO Nesbitt Burns Inc., please contact your Investment Advisor for more information. All insurance products and advice are offered through BMO Nesbitt Burns Financial Services Inc. by licensed life insurance agents, and, in Quebec, by financial security advisors. ®”BMO (M-bar roundel symbol)” is a registered trade-mark of Bank of Montreal, used under licence. All rights are reserved. No part of this publication may be reproduced in any form, or referred to in any other publication, without the express written permission of BMO Wealth Management.
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