Floating Rate Notes: Overpaying for Insurance That Doesn't Protect You
So far, 2013 has been an excellent year for floating rate bond
issuance. At the end of the first quarter, floating rate issuance
was nearly 2.5x the prior year's pace during the first quarter.
According to JPMorgan, US companies issued $30.045 billion during
the first quarter, up from $13.250 billion in the 1Q 2012. Much of
this issuance has been for debt maturing in five years or less, for
a reason we'll get into later. The general buying interest was due
in large part to investors seeking protection from rising interest
rates. As the Fed would pull back on its purchases, the epic bond
bubble would burst and rates would go through the ceiling they had
provided. While I do think this is a flawed line of thinking, I
will attempt as much as humanly possible to not harp on this
Floating rate notes typically are "fixed-to-floating" or pay a spread over a floating rate, such as 3-month LIBOR or 3-month T-bill. So as monetary conditions tighten or loosen, these rates should react accordingly. The problem is that with the Fed funds rate -- or overnight rates -- at zero, there is only so much 3-month LIBOR can move, barring a tail event such as a liquidity crisis. As such, if Treasury rates rise, LIBOR will remain in a tight band.
The issuer, on the other hand, stands to profit from this scenario. On average, high-grade firms such as Coca-Cola ( KO ) and Caterpillar ( CAT ), and banks such as Goldman Sachs ( GS ), Wells Fargo ( WFC ), and Morgan Stanley ( MS ), have been able to issue floating rate debt at 50-60bps discounts from where they can issue fixed debt, depending upon the maturity. As the issuer, you feel comfortable that rates are unlikely to rise materially from here because the Fed has said that policy will remain at the zero-bound until at least 2016, and potentially beyond. So these companies issue 2-, 3-, and 5-year floating debt to capture that guarantee of sorts, and have low odds of paying higher rates.
Investors, on the other hand, are paying up for what is perceived to be interest rate insurance. Compared to fixed coupon debt, floating rate debt pays a higher rate when interest rates rise, as the rate resets every quarter or semi-annually. In a normal environment, this would be the case. Operating under the assumption that the Fed has entered unprecedented monetary accommodation with the thought of never exiting and correspondingly keep rates at or near zero until 2020, then LIBOR is basically stuck.
For example, in late 2010 Treasury rates moved from their cycle low on the back of more asset purchases from the Federal Reserve to a high in the spring and early summer. Into the spring months, the 5-year Treasury rate went from 1.1% to about 2.15%. During that same time frame, 3-month LIBOR rose from 28.5bps to 30.5bps. So if you had purchased floating rate bonds as insurance toward higher rates, then your insurance did not pay out as expected. This is not to say I believe investors are buying these notes as a non-traditional hedging source. I am only pointing out that the expected rate of return would not equal the credit risk and the original buying purpose. There are better investment vehicles.
A good example of the growing interest in floating rate notes is represented by the iShares Floating Rate Note ETF (NYSEARCA:FLOT). Over the past 12 months, shares outstanding in the fund have experienced exponential growth, from 2.1 million to 30.4 million. Or in market cap terms, from $104.895 million to $1.540 billion. The fund invests in similar assets that I have described, floating rates notes with a maturity of less than five years. This matches up with the heavy demand for institutional investors in the corporate bond market.
There are a few reasons why I think LIBOR will remain at or near zero. Currently there is $1.8 trillion of excess reserves that new loan demand has to eat through before conditions begin to normalize. That is a lot of escape velocity. A Fed exit. Because the Fed is currently the marginal buyer, this has kept rates marginally suppressed; roughly 20bps lower for the 10-year, depending on which economist or strategist you talk to.
There is one flaw in my argument, and that is the Interest on Excess Reserves (IOER) rate. It remains to be seen whether or not the Fed will use this tool in conjunction with tri-party reverse repos to drain excess reserves from the system before it begins raising the Fed funds rate, though they have hinted as much. What I am unsure of is how this will affect money market rates, as we've never experienced anything like it in the history of American capital markets. If economic theory holds true, this tightening would cause short-term funding rates to rise as the demand for money increases, but I am not sold on how that concept works out in reality.