Rising Rates: When to Consider Floating-Rate Notes

Floating-rate notes can help lower a portfolio’s sensitivity to interest rate changes, but they aren’t necessarily the secret weapon to combat a rising-rate environment. Investors may want to consider floating-rate notes today, given general expectations that interest rates are likely to rise. However, if the Federal Reserve doesn’t raise short-term rates for a year or more—as is currently broadly expected—investors in floating-rate notes could miss out on the higher yields and higher income payments that short-term fixed-rate corporate bonds may offer.

Why are floating-rate notes worth a look? They can help lower the average “duration” in a portfolio. Duration is a measure of interest rate sensitivity; the higher the duration, the greater the price decline when rates rise. The average duration for floating-rate notes is currently near zero.

In our view, investors should continue to favor bond investments with low average durations to help limit the impact of rising Treasury yields on their portfolios, but there may be better options right now than floating-rate notes. Here’s what you should know.

The basics of floaters

Investment-grade floating-rate notes, or “floaters,” are a type of bond investment whose coupon payments are referenced to a short-term benchmark, like the three-month London Interbank Offered Rate (LIBOR). The coupons usually comprise the reference rate plus a “spread” meant to compensate investors for the potential default risk of lending to a corporation. Floater spreads tend to be relatively low, because the companies generally maintain investment-grade ratings.

The short-term reference rates tend to follow the lead of the federal funds rate, so floater coupon rates tend to rise and fall depending on whether the Fed is raising or lowering rates. More importantly, floater coupon rates do not fluctuate due to changes in other Treasury yields. The surge in the 10-year Treasury yield has made headlines all year, but that has had no impact to floater coupon rates.

Floater coupon rates tend to follow the lead of the federal funds rate

Source: Bloomberg, using weekly data as of 4/2/2021. Bloomberg Barclays U.S. Floating Rate Note Index (BFRNTRUU Index) and U.S. Federal Funds Target Rate Mid Point of Range (FDTRMID). Past performance is no guarantee of future results.

Floaters can make sense in an environment when interest rates are rising, because their prices are not very sensitive to changing interest rates. For fixed-rated bond investments, prices and yields move in opposite directions. That’s a key reason why investors tend to be anxious about what a rising-interest-rate environment might mean for their bond holdings.