Home Account PricesPerformance Funds Retirement College Education

New window: AdvantageVoice - Opening the door to investment conversations. Read our new blog.
Economic News & Analysis—February 26, 2013

Is it too soon to choose floating over fixed rates?

By James Kochan, Chief Fixed-Income Strategist, and Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist

The two basic types of floaters

There are two basic types of floating-rate fixed-income investments: floating-rate notes (FRNs) and bank loans.

  • FRNs, essentially, are bonds that are issued with coupon payments indexed to a benchmark interest rate. The benchmark is typically the LIBOR (London Interbank Offered Rate), but it can also be a U.S. Treasury yield or a prime rate. The coupon rate is typically set at a fixed spread over the benchmark interest rate. However, depending on the issuer, the spread could be negative. There could also be caps or floors on the coupon rate, meaning that the coupon rate may not exceed or fall below a certain percentage. An FRN typically has a coupon rate that changes every six months, but for a certain period of time, the rate may be fixed before it begins to float. The majority of issuers of FRNs are investment-grade companies.
  • Bank loans are sometimes called senior loans, leveraged loans, or syndicated loans. Regardless of the label, these are loans made by banks, bundled together, and sold to investors. The senior label refers to a loan that sits in the capital structure of the company borrowing the money. Basically, senior loans get paid first. This can provide some comfort to lenders if the borrower gets into financial difficulties. Many senior loans are also backed by collateral, meaning that the lender can go after an asset if payment is not made.

    Another common feature of bank loans is that they are typically loans to below-investment-grade borrowers. This makes a bank loan a type of junk loan, where the creditworthiness of the borrower is less than prime and can change—sometimes dramatically. As a result, yields on these loans are typically higher than they are on investment-grade bonds. However, because the loans are senior and sometimes collateralized, the yields may be lower than they are on high-yield bonds.

    Perhaps the biggest selling point to investors of bank loans is that the rates paid on the loans adjust according to a formula. A bank loan has a reference rate, often the LIBOR. The rate paid on the loan will then adjust as the reference rate changes, but only periodically—typically quarterly or monthly. The actual rate paid on the loan is equal to the reference rate plus a fixed amount called the spread.

The danger of floating features

The floating-rate feature of any investment is either a benefit to the bond issuer or buyer; thus, it comes at a price.

  • The floating-rate feature may turn out to be costly. When rates are high and expected to decline, the floating-rate feature is a benefit to the borrower. When rates are low and expected to rise, the floating-rate feature is a benefit to the buyer—that is, the investor. In today’s environment, investors seem to be willing to pay for the floating-rate feature, meaning that the yield on the investment may be lower than that on an otherwise identical fixed-income security. Thus, if rates don’t rise as quickly or as much as expected, that floating-rate feature may turn out to be more costly than the investor expected.
  • The bond or loan may perform poorly just when it is supposed to protect against rising rates. The market-required spread on bank loans or FRNs can change with time or conditions. When bank loans or FRNs are issued, the spread may seem fair, but if rates rise, it is possible that the creditworthiness of the borrower can change, perhaps requiring a larger spread. As a result, while the rate can go up with the reference rate, the actual market price of the loan or FRN can decline if the spread no longer represents a fair compensation for the default risk of the borrower. This is what likely happened in the late 1970s to early 1980s when rates went up but economic conditions deteriorated.

We do not believe rates are going to rise before the end of the year, meaning that it may be too soon to consider floating rates over fixed rates. Also, because investment results will depend critically on determining whether the spread will be fair if rates do rise, we think investors should be very cautious and diligent in doing credit analysis on the issuers of these instruments to be comfortable with the spread they receive over the reference rate. It’s not just a matter of determining whether the spread today seems fair but whether the spread in the future will continue to be fair as economic conditions change.

Back to Recent Commentaries

  • Not FDIC Insured
  • No Bank Guarantee
  • May Lose Value

Wells Fargo Advantage Funds

  • Individual Investors · 1-800-359-3379
  • Investment Professionals · 1-888-877-9275
  • Institutional Sales Professionals · 1-866-765-0778