Floating-rate bonds get boost amid Fed taper tantrum
The strong appetite for floating rate bonds might be tested by volatility, triggered by the Fed’s decision to delay tapering, but for now demand for investment-grade floaters, in particular, is red-hot, leaving bankers and investors to ask how long the rally can last.
Floating rate bonds have proved to be an extremely popular form of debt issuance as investors worry about a rise in global interest rates.
Globally, non-financial corporates have issued $77 billion of floating rate notes (FRNs) so far this year, more than a two-fold increase on the $27 billion issued during the same period in 2012, according to Dealogic.
Global issuance across dollars, sterling and euros is running at its highest level since 2007.
Banks and insurance companies have long preferred to issue floating rate paper, Banks lend at variable interest rates, so issuing FRNs allows them to better match assets and liabilities.
However, the increased take-up of floaters by corporate issuers is new. This month, when Verizon Communications raised a record $49 billion in the US bond markets, it attracted $11 billion of orders for two floating rate tranches totalling a combined $4 billion.
More than half of this year’s tally of FRNs has been issued since May, when markets reacted negatively to comments from the Federal Reserve chairman Ben Bernanke that the Fed would look to start scaling back its bond-buying programme.
Bernanke’s words sent Treasury rates higher and fuelled fears of another sell-off in treasuries once tapering begins.
“Floating rate notes have been the classic defensive instrument in a rising rate environment,” says one industry source.
Market participants have suggested in recent months the thirst for floating rate paper could come to an end once there is clarity over the interest-rate horizon. However, Bernanke’s unexpected announcement that the Fed would maintain quantitative easing at its current rate, as the Federal Open Market Committee voted against tapering at its two-day meeting, has further boosted demand for the product. The announcement confounded the expectations of many market commentators, who had predicted tapering and, as a result, a rise in the 10-year Treasury note beyond 3%. Instead, equity markets rose to new highs and the 10-year Treasury note dropped to 2.7%, down from a two-year high of 2.99% on September 3.
The three-year floater is the sweet spot for investment-grade investors, although the growing demand has spilled over into a longer tenor, and more companies are issuing five-year FRNs.
One of the most popular combinations for borrowers and investors at the short end has been a mixture of five-year fixed and FRNs. “There’s no overlap in the investor base,” says one strategist. “The casualty in the rise of the three-year floater has been the three-year fixed-rate note.
“If you look at the yield curve since May, when tapering was first mentioned, there has been a big steepening upwards in five-, 10- and 30-year paper. The Fed has always said it will keep short-term rates low so the spike in three-year rates has been around 45 basis points versus 100bp on the 10-year. So the three-year fixed is less appealing to investors.”
By contrast, the three-year floater is popular because a steepening yield curve means a steepening forward Libor curve, so that makes the floater more appealing.
More than $320 billion in new floating rate bonds with credit ratings of below investment grade have been issued, according to S&P Capital IQ, and that could hit $450 billion by year-end, surpassing the record set in 2007.
In a rising-rate environment, investors might prefer investment-grade floaters instead as part of a flight from riskier assets, but experts do not think the decision to delay tapering will affect the appetite for FRNs.
“I’ve been hugely impressed by the depth of demand for floaters,” says a source at a European corporate borrower. “I guess it has to run out of steam at some point, but I don’t see it happening yet.”
The strategist agrees: “Investors tend to react adversely when a deal is badly priced, so when that happens, we may see a correction.”
Not all investors are fans of the floater. “We prefer to hedge interest rate exposure on a portfolio level rather than buying floaters, as it gives you greater flexibility and more upside in this volatile interest-rate environment,” says Pieter Heijboer, portfolio manager for European investment-grade credit at ING Investment Management.
“Fixed coupon bonds also tend to be more liquid than floaters.”