Fixed or floating? Bond investors continually find themselves asking this question in their quest for higher returns.
Some investors will be limited in their choice due to mandate restrictions. However for those investors who aren’t, it is a topic that should be given some consideration as in the current market dislocation there are clear examples of where ‘floaters’ are clearly better value than fixed securities and vice versa.
Basically the decision of whether to buy a fixed or floating security depends on your view of where interest rates will go — or to be more precise, where interest rates will go compared to the prevailing expectation in the market.
In the current environment with interest rates at record lows, it’s not exactly going out on a limb to predict interest rates will rise in coming years, the trick is to determine just how high they will go and how quickly.
For bond investors, the most relevant benchmark of the market’s expectation of where interest rates will go, and how quickly, are swap rates. The difference between the floating rate benchmark, usually the 90-day bank bill swap rate (BBSW), and the swap rate reflects the market’s expectation of interest rate movements.
Since the start of the year, the difference between the three-year swap rate and 90-day BBSW has increased dramatically. Early in the year, the 90-day BBSW was actually higher than the swap rate, however, that trend has reversed.
The gap between the two figures is now substantial and at one point in late June the three-year swap rate was 1.68 per cent higher than the 90-day BBSW. While that gap has narrowed since then, there is still a significant difference between the two figures.
Brookfield bonds
A good practical example is the recently issued Brookfield Bonds, which are a fixed rate security being marketed at 3.25 per cent above swap.
As the securities have a three-year maturity, the relevant benchmark is the three-year swap, which was 4.57 per cent at the time the Brookfield Bonds were issued. That makes for a total return of 7.82 per cent fixed for the three-year duration of the bond.
If the Brookfield Bonds had been marketed as a floating rate note, they most likely would have been offered at the same margin (3.25 per cent), but over the 90-day BBSW, which was only 3.14 per cent at the time the securities were priced. So, the initial coupons on the floating rate version of this security would only be about 6.39 per cent — or about 1.43 per cent less than the fixed rate the Brookfield Bonds were actually offering. This amount would then rise and fall with changes in the 90-day BBSW, which is highly correlated to official interest rates.
This difference in coupons reflects the expected movement in future interest rates.
In this case, interest rates are expected to increase rapidly, representing a steep positive curve, to use some finance vernacular.
So while investors in the fixed rate notes initially receive higher coupons, the expected rapid increase in the floating rate note coupons means the overall returns should be the same — or so the theory says.
The simple way
Of course, finance isn’t anywhere near as efficient as the academics make out and there are a number of ways to calculate whether as an investor you are better off holding the floater versus the fixed note.
The simple way is to just forecast what the 90-day BBSW will be over the life of the bond on coupon dates, take the average of these amounts and compare it to the three-year swap rate. Whichever works out the highest is the preferred bond.
The problem with this method is that it doesn’t take into account factors such as the time value of money, which ascribes greater value to the earlier coupons than the latter ones. However, as a quick calculation tool it is quite effective and, in most cases, will provide an excellent guide on what return is required to make a fixed note more attractive than a floater, or vice versa for that matter.
The not so simple (but far more accurate) way
For those investors who want to get more technical, the pointy-headed boffins can create spreadsheets to calculate the different value in fixed and floating bonds down to the exact cent.
These models account for variables such as changes in the BBSW throughout the life of a bond and the present value of future cash flows. They are powerful tools in that they can simulate different scenarios and calculate breakeven points for fixed and floating bonds.
In a practical sense these models can also discover inefficiencies in bond prices.
Currently we are seeing both the fixed and floating version of a financial services bond available in the market at the same price.
By using these models, we can calculate, using current forward interest rate assumptions whether the fixed or floating note currently offers better value. Sometimes the discrepancies are significant as is the case with these two bonds.
This means one of two things. Firstly, either the fixed or the floating bond is much better value than the other (the fixed in this case), or the market’s expectations of future interest rates is wrong.
Either way, inefficiencies such as this provide the opportunity for investors to profit.
Fixed or floating?
So what is currently better value — fixed or floating? It depends on the time frame but based on the duration of the asset, particularly shorter-dated securities (one to three years), the answer is generally fixed.
Let’s go back to the Brookfield example — a three-year bond with a fixed rate 1.43 per cent higher than the theoretical floating rate note.
We believe that interest rates will stay put, and even potentially fall, for the short to medium term. All that time investors in a fixed-rate bond will be receiving substantially higher coupons.
When interest rates do eventually increase, 1.43 per cent is a significant amount to rise before the floating rate note breaks even with the fixed rate. Rates will then have to rise considerably above the current three-year swap rate if the average coupon of the floaters is to equal the fixed amount — and that doesn’t even take into account the discounting of the coupons that places more value on the higher fixed amounts.
So just because the fixed and floating version of a bond is offered at the same price doesn’t mean they are equal value.
By using a combination of maths tools and a view on interest rates, investors can often find bonds that will generate superior long-term returns.
Brad Newcombe is a senior research analyst at FIIG Securities.
