Unlike
a plain-vanilla bond, which pays a fixed rate of interest, a floating
rate bond has a variable rate that resets periodically. Typically, the
rates are based on either the federal funds rate or LIBOR plus an added
“spread.” For instance, a rate could be quoted as
“LIBOR + 0.50%;” if LIBOR stood at 1.00%, the rate
would be
1.50%. While the yield changes throughout the life of the security as
prevailing interest rates change, the spread (the
“+0.50”
in the example above) typically stays the same. The frequency at which
the yield of floating rate note resets can be daily, weekly, monthly,
or every three, six, or 12 months. Corporations, municipalities, and
some foreign governments typically offer floating rate securities
– which are sometimes called “FRNs”.
How to Invest in Floating Rate Bonds
Investors can purchase individual floating rate bonds through a broker, or they can invest in mutual funds that invest only in floating rate securities. As of October 2011, two exchange-traded funds (ETFs) were available for those who sought to invest in floating rate notes: iShares Floating Rate Note Fund (ticker: FLOT) and Van Eck Market Vectors Investment Grade Floating Rate Bond ETF (ticker: FLTR).
Keep in mind, in the United States FRNs are typically offered by below-investment grade companies. As a result, many floating rate funds have a similar degree of risk as high-yield bond funds – but without the high yield. Be alert to this potential risk before making any investment in a fund or individual security.
Some diversified bond mutual funds also invest in floating-rate securities. Unless the fund is specifically designated as a floating rate fund, these bonds typically make up only a small segment of the portfolio. Managers often use them as a way to protect the fund when they expect that rates are going to rise.
The Pros and Cons of Floating Rate Securities
The advantage of floating rate bonds, compared to traditional bonds, is that interest rate risk is largely removed from the equation. An owner of a fixed-rate bond can suffer if prevailing interest rates rise, since the bond is paying a below-market rate. For an investor in individual bonds, the risk of declining principal value is only an issue if he or she has to sell the bond prior to maturity. For the owner of a mutual fund that invests in fixed-rate securities, however, the risk of declining principal value in a rising-rate environment is more of a problem since the fund itself never matures. In contrast, floating rate notes will pay higher yields if prevailing rates rise. As a result, they will tend to perform better than traditional bonds when interest rates are rising.
The flip side, of course, is that investors in floating rate securities will receive lower income if rates fall because their yield will adjust downward. Also, investors in individual floating rate bonds lack certainty as to the future income stream of their investments. With fixed-rate securities, you will know exactly what you will be paid through the bond’s maturity date.
What is the Best Time to Invest in Floating Rate Notes?
The best time to buy a floating rate notes is when rates are low, or have fallen quickly in a short period, and are expected to rise. Conversely, plain-vanilla bonds are more attractive when prevailing rates are high and expected to fall.
Floating rate notes are also an attractive option for investors whose primary concern is maintain a portfolio return that keeps up with the rate of inflation. If you are considering Retirement Planning, call for a free consultation today.
How to Invest in Floating Rate Bonds
Investors can purchase individual floating rate bonds through a broker, or they can invest in mutual funds that invest only in floating rate securities. As of October 2011, two exchange-traded funds (ETFs) were available for those who sought to invest in floating rate notes: iShares Floating Rate Note Fund (ticker: FLOT) and Van Eck Market Vectors Investment Grade Floating Rate Bond ETF (ticker: FLTR).
Keep in mind, in the United States FRNs are typically offered by below-investment grade companies. As a result, many floating rate funds have a similar degree of risk as high-yield bond funds – but without the high yield. Be alert to this potential risk before making any investment in a fund or individual security.
Some diversified bond mutual funds also invest in floating-rate securities. Unless the fund is specifically designated as a floating rate fund, these bonds typically make up only a small segment of the portfolio. Managers often use them as a way to protect the fund when they expect that rates are going to rise.
The Pros and Cons of Floating Rate Securities
The advantage of floating rate bonds, compared to traditional bonds, is that interest rate risk is largely removed from the equation. An owner of a fixed-rate bond can suffer if prevailing interest rates rise, since the bond is paying a below-market rate. For an investor in individual bonds, the risk of declining principal value is only an issue if he or she has to sell the bond prior to maturity. For the owner of a mutual fund that invests in fixed-rate securities, however, the risk of declining principal value in a rising-rate environment is more of a problem since the fund itself never matures. In contrast, floating rate notes will pay higher yields if prevailing rates rise. As a result, they will tend to perform better than traditional bonds when interest rates are rising.
The flip side, of course, is that investors in floating rate securities will receive lower income if rates fall because their yield will adjust downward. Also, investors in individual floating rate bonds lack certainty as to the future income stream of their investments. With fixed-rate securities, you will know exactly what you will be paid through the bond’s maturity date.
What is the Best Time to Invest in Floating Rate Notes?
The best time to buy a floating rate notes is when rates are low, or have fallen quickly in a short period, and are expected to rise. Conversely, plain-vanilla bonds are more attractive when prevailing rates are high and expected to fall.
Floating rate notes are also an attractive option for investors whose primary concern is maintain a portfolio return that keeps up with the rate of inflation. If you are considering Retirement Planning, call for a free consultation today.
