Floating Rate Bonds – why buy them?

 

Bond or Debt obligations with coupon payments that are floating in nature are referred to as floating rate bonds. Issuers of these bonds are no different from those for fixed rate bonds i.e. government, government sponsored enterprises, private financial institutions, corporates et al. Bank Loans that are priced on a variable benchmark are also of the nature of floating rate debt.

A floating rate coupon typically references a known market benchmark index and has a spread component (quoted in basis points) i.e. sum of the benchmark index yield and spread form the floating rate coupon. In case of the US treasury floating rate note – product introduced in 2013 - the reference benchmark is the 13-week treasury bill yield – while for floating interest payments on US corporate bonds reference the treasury bond itself along with a credit spread. The spread typically determined at the new issuance/initial auction, stays constant through the re-issuance of the bond.   

Understanding the cash flows of a floating rate bond would explain the rationale for owning these bonds. Since the coupon on these bonds reference a variable benchmark, it resets periodically in response to changing market conditions which intuitively implies that the duration (and convexity) of a floating rate bond is like that of a fixed rate bond with a tenor same as the reset period of the floating coupon. Buyers of these bonds foresee a rising interest rate environment that they can benefit from (if their view holds right) with every reset of the floating coupon. Despite the periodic coupon resets (and hence reduced interest rate sensitivity) however the pass-through into the floating benchmark may still be smaller than the changing market rates. 

Present value of a floating rate bond for academic simplicity is same as/close to par assuming the implied forward coupon rate is also the discount rate of the series of cashflows. For further understanding of this valuation please visit pandemonium.sg – a warehouse of financial market knowhow that tackles the concept with logic and intuitive ease.