What is a floating rate bond
By Vanguard
The basics
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Floating rate bonds explained: income that adjusts as interest rates change
The Reserve Bank’s recent interest rate increases are a reminder that the path of inflation and interest rates remains uncertain. For investors, that raises an important question: how might changes in interest rates affect different types of fixed income investments?
One type of fixed income investment whose income responds to changes in short-term interest rates is a floating rate note (FRN), or floating rate bond.
Unlike fixed rate bonds, which pay a fixed rate of interest for the life of the investment, floating rate notes pay a coupon that adjusts as market interest rates change. This means investors may benefit from higher income when rates rise, while potentially reducing some of the interest-rate risk associated with fixed-rate bonds. However, their income can also fall when the reference rate declines and their market value remains exposed to credit, liquidity and other market risks.
How do floating rate notes work?
Most bonds pay a fixed coupon. For example, a bond issued with a 4% coupon continues paying that rate regardless of what happens to interest rates in the broader economy.
Floating rate notes work differently. Their interest payments are linked to a short-term reference rate, most often the three-month Bank Bill Swap Rate (BBSW), plus an additional margin known as a credit spread.
As short-term interest rates rise or fall, the coupon paid by the bond is periodically reset to reflect those changes. This means the income generated by floating rate notes can move with market conditions rather than remaining fixed.
Why does this matter when rates are rising?
When interest rates rise, existing fixed-rate bonds may become less attractive because newly issued bonds offer a higher yield. As a result, the prices of fixed-rate bonds can fall.
Floating rate notes are less affected because their coupons are regularly updated.
Put simply:
- With a fixed-rate bond, the income stays the same and the price typically adjusts when rates move.
- With a floating rate note, the coupon generally adjusts as short-term interest rates change, which typically reduces sensitivity to changes in benchmark interest rates compared with an otherwise similar fixed-rate bond.
While floating rate notes can still be affected by market conditions and credit risk, they have historically been less sensitive to changes in interest rates than many fixed-rate bonds.
What are the potential benefits?
- Income that adjusts with interest rates – coupon payments can rise when short-term interest rates increase.
- Lower interest-rate risk – quarterly coupon rate resets help reduce sensitivity to changes in rates.
- Diversification – can complement cash and fixed rate bonds within a portfolio.
What are the risks?
- Credit risk – if the issuer of the bond experiences financial difficulty, investors could lose money.
- Lower income if rates fall – interest payments can decrease if short-term interest rates decline.
- Market and liquidity risk – the value of floating bonds can still go up and down as markets change.
Factors to consider when assessing floating rate notes
Investors may wish to assess factors including:
- The investment’s interest-rate sensitivity
- Credit quality
- Liquidity
- Expected income
- Fees
- That the diversification characteristics fit with their objectives, financial situation and needs.
Floating rate notes may form one part of a diversified portfolio rather than a replacement for all bonds. However, they have different risks from both cash and fixed-rate bonds and should not be treated as equivalent to a cash deposit.
Exposure to floating rate notes is available through managed funds and ETFs. One example of a product that invests in floating rate notes is the Vanguard Australian Floating Rate Bond Index ETF (ASX: VFLT). Information about the fund’s investment objective, strategy, risks and costs is available in the Product Disclosure Statement.
As with any investment, floating rate notes involve risks and may not be suitable for every investor. They are generally best considered as part of a diversified portfolio aligned with an investor’s goals, time horizon and risk tolerance.
Important Information:
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