Fixed Income  

Plan for headwinds by using high-yield FRNs

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Investing in Fixed Income - November 2015

We are entering a new era for interest rates in the developed world. The extended period of ever looser monetary policy is starting to draw to a close. Now that quantitative easing has ended in the US, investors are bracing themselves for the first interest rate rise in many years, which will likely happen in the US, with the UK following suit.

For bond investors in particular, this transition has thrown up a lot of difficult questions. Having benefited greatly from falling yields and tightening credit spreads, the move to a more hawkish cycle will create many more headwinds and challenges when it comes to delivering returns.

Aware of this, the investment sector has been paying close attention to new tools to navigate this environment. High-yield floating-rate bonds (FRNs) have emerged as one of retail investors’ main instruments in this respect, gaining popularity with many issuers and seeing a growth in the market of more than $40bn (£26bn).

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This growth is not surprising if we take into account the potential benefits for both investors and issuers. On one hand, with FRNs investors can receive attractive income streams now, while potentially benefiting from higher coupons when interest rates increase with no associated losses to capital.


On the other hand, by issuing high-yield FRNs, companies can retain a similar debt structure to bank loans, but access deeper and more diverse sources of debt capital. The good diversification of global underlying issuers of high-yield FRNs – both by geography and sector – is yet another sign of the rude health of this market.

When it comes to high-yield FRNs there are three characteristics to keep a close eye on. High-yield FRNs offer:

• A floating-rate coupon automatically adjusted in line with changes in interest rates;

• Relatively high credit spreads that reflect the additional credit risk of a non-investment-grade issuer; and

• An interest rate duration close to zero.

The third point – the lack of a hit to capital in a rising interest rate environment – is the key difference of high-yield FRNs to traditional fixed coupon bonds, which suffer from price declines as yields move up.

Credit spreads

Investors should note, however, that as non-investment-grade instruments, there is still exposure to movement in credit spreads within high-yield FRNs. Spread duration for the high-yield floating-rate market is around 2.6 years. Accordingly, if spreads were to widen on average by 100 basis points, there would be an associated capital loss of around 2.6 per cent, and vice versa if spreads were to tighten.

However, the spread duration is significantly lower than that of the more traditional high-yield universe – 4.2 years. This means that in times of risk aversion and widening credit spreads, the impact on prices for the high-yield floating-rate market should be comparatively lower.

A new monetary cycle calls for new tools. High-yield floating-rate bonds offer a good combination of characteristics for fixed income investors, namely exposure to credit spreads alongside materially lower interest rate risk. Consequently, the development of this market should give bond investors a new tool that not only mitigates the potential headwinds of higher interest rates, but also gives them something that actually benefits from the next phase of the monetary policy cycle.