Why invest now in floating-coupon bonds

With inflationary pressures and potential monetary tightening, variable-rate bonds are gaining appeal by mitigating sensitivity to interest rates and providing defensive returns, although they require monitoring solvency, liquidity, and potential aggressive cuts by the ECB.

The conflict in Iran and the energy crisis are causing an increase in inflation and realigning the monetary policies of central banks to the point that they are now more likely to raise their interest rates than the opposite, as was the case at the beginning of the year.

The above implies that investing in floating rate notes ( FRNs) now makes more sense given the interest rate environment described and how they perform compared to traditional fixed-rate notes.

What is a floating coupon bond and what advantages does it offer?

Unlike a standard fixed-rate bond, the coupon of a fixed-rate bond is adjusted periodically based on a market benchmark (such as Euribor) plus a spread. In other words, if the bond has a coupon of 3-month Euribor + 2%, if Euribor rises, the interest rate also rises, and if it falls, the coupon rate decreases.

This type of bond offers better protection against interest rate hikes or general uncertainty. When central banks maintain relatively high rates or there is uncertainty about the direction of inflation, as is currently the case, fixed-rate bonds can lose value if yields (YTMs) tend to rise, as is happening this year.

In contrast, FRNs tend to suffer less because their coupons are automatically adjusted, or in other words, the «duration» of a bond, which measures how much its price moves when interest rates change, is very low in an FRN.

Thanks to this, even if a bond has a long maturity, for example five years, the coupon review mechanism of the FRNs means that its duration usually approaches the time until the next adjustment . If the adjustment period is monthly, the maturity may be long, but the sensitivity to interest rates remains small since the duration will be around one month.

Although the conflict in Iran may soon end (it now seems, only seems, that the end is closer), we expect to see further episodes of volatility in fixed-income markets in the coming months, with investors demanding that governments address their fiscal constraints (enormous deficits and issued debt), making an active approach to duration management, as I am describing, essential.

Risks of this type of investment

Floating coupon bonds also have disadvantages , since if interest rates fall, the coupon will be lower and therefore the return on investment will also be lower.

Although it is not the most likely scenario now, if the ECB were to begin aggressively cutting interest rates, future coupons on FRNs would fall, and consequently, their yield. Conversely, fixed-rate bonds would rise in price in that context.

Furthermore, as with any fixed-income issue , FRNs also carry the risk of default due to the issuer’s insolvency and liquidity risk in some issuers, in addition to the risk of widening spreads (the additional yield that the market demands over the return of a sovereign bond), especially during times of market stress due to declining economic growth and reduced repayment capacity of issuers.

Types and methods of achieving exposure to floating coupon bonds

Investment-grade corporate bonds, senior bank debt, and high-yield bonds , particularly those from Nordic countries, typically offer very safe issues with extremely low default rates. Their defensive nature makes them well-suited for the conservative portion of a portfolio , enhancing the return profile of other alternatives such as deposits or traditional money market and short-term fixed-income funds.

To gain exposure to this type of fixed income, the best way is through investment funds classified within this category. Regarding floating-rate bonds, few asset managers, mostly international (primarily French and Nordic), manage funds or ETFs whose portfolios consist entirely of floating-rate bonds.

Currently, inflation remains a concern (recent data shows a rise to almost 4% in the US and slightly above 3% in Europe), and the likelihood of central banks raising their benchmark interest rates is increasingly credible, with or without the conflict in Iran. If you want to reduce the volatility of the fixed-income portion of your portfolio and provide it with the expectation of higher returns (more than just beating inflation, unlike traditional fixed-income funds), here is a transparent and accessible option. Given the current interest rate environment, a fixed-income investment fund from a top-tier asset manager is currently a good solution for any type of investor.