In this interview Mohammed Kazmi sets out to Bernard McGrath his case for investing in floating-rate notes as a way to reduce portfolio exposure to interest rates and gain from widely expected Fed rate hikes in the months ahead.
Bernard McGrath: In recent weeks, some of the larger central banks have pivoted towards raising rates. In fixed income markets, popularity for floating-rate notes has increased. Can you remind us what they are?
Mohammed Kazmi: Floating-rate notes (FRNs) are bonds issued with variable interest rates. At successive intervals, typically quarterly, the FRN coupon is reset according to a predetermined benchmark rate. Should the benchmark rate move up, as it does in a hiking cycle, the coupon on the FRN will increase as well.
Bernard: What about interest rate exposure, are FRNs affected by rising yields?
Mohammed: As a consequence of the frequent coupon reset, FRNs have little or no interest rate duration, meaning they do not suffer capital losses from rising yields. In addition, an FRN’s coupon increases in a hiking cycle, which means it can be a very interesting segment of the market to have exposure to at this current juncture.
Bernard: Fixed income markets have responded to the expectation of future rate hikes. Is it too late to go into FRNs?
Mohammed: Whereas fixed-coupon bonds have adjusted yields in anticipation of seven future rate hikes over the coming two years, FRNs do not respond until actual hikes are delivered. Investors still wishing to take advantage of the hiking cycle can therefore still position themselves in FRNs today and benefit.
Bernard: What about supply? Are these bonds available and are they liquid?
Mohammed: Supply and demand for FRNs is directly linked to the central bank cycle. If central banks are hiking rates, demand for FRNs increases and corporates respond by issuing more FRNs. Similarly, if central banks are cutting rates, investor demand for FRNs decreases and fewer are issued. With the hiking cycle beginning in the US, already started in the UK, and expected by year-end in Europe, investor demand for FRNs has increased. Corporates have responded and supply is increasing too. As for liquidity, investment-grade FRNs are very liquid, with tight bid/offer spreads in the market.
Bernard: As FRNs have no interest rate exposure, the risk for these instruments is on the credit side. How are investment-grade companies from a fundamental perspective?
Mohammed: We see investment-grade companies as being in a strong position from both a macro and a micro perspective. Credit fundamentals are impressive, following stellar earnings growth in 2021 with prudent balance sheet management. This can be seen in net leverage for US investment-grade names, which have fully reversed the increase observed during the pandemic. From a macro perspective we expect growth to be resilient as economies look to move on from the pandemic, and it is the strength of the US economy and labour market that has allowed the Fed to focus more on inflation.
