Understanding floating rate notes

For investors seeking stable and increased income above bank deposit rates, it is important to understand the nature of the underlying investment to properly assess the risks and potential opportunities of fixed income products. Here, we present a primer on floating rate notes compared to Australian Government bonds.    

A floating rate note (FRN) is a type of bond. A borrower, typically a government or company, issues bonds to raise capital. In return, they promise to pay bond holders back in full on the bond’s maturity date. Until that date, the borrower pays regular interest payments (called coupons). Repayment depends on the borrower meeting its obligations.

Just like other bond investments, an investor can sell a floating rate note before its maturity date.

Bonds are commonly called ‘fixed income investments’. But the term ‘fixed income’ should not be mistaken for a guarantee that income derived from a bond is ‘fixed’ or that bonds pay a fixed yield.

The difference between fixed and floating rate bonds

FRNs are a type of bond that pay variable coupons. This is the key differentiator between FRNs and other types of bonds. A fixed rate bond’s coupon interest rate does not change from the time the bond is issued through to its maturity.

An example is a conventional Australian Government Treasury Bond. A Treasury Bond with a 5% coupon interest rate will pay investors $5 a year per $100 face value in coupon payments.

With FRNs, the coupon interest rate is variable, or ‘floating’, which means it tracks a reference interest rate.

This has the effect of preserving the capital value of the bond in a rising interest rate environment. FRN coupon interest rates are most commonly set by reference to the 90-day bank bill swap rate (BBSW), which in turn is influenced by the RBA cash rate as well as the market’s expectations for interest rates. For example, an FRN may be issued with a face value of $100 for 3 years with a coupon of ‘3-month BBSW + 1%’.

This means coupon payments will increase if the benchmark 3-month BBSW interest rate rises or decreases as the 3-month BBSW interest rate falls. The coupon interest rate of a FRN is usually reset each quarter to capture any changes in the benchmark BBSW.

The coupon interest rate is different to the ‘yield to maturity,’ which is the rate of return expected on a bond (expressed as an annual rate) if purchased at the current market price and held until the maturity date. The yield to maturity will vary with the price of the bond which is subject to a variety of factors.

Factors affecting a bond’s market price

The market price of a bond will vary over time depending on what's happening in the economy and with interest rates, as well as any changes in the credit worthiness of the borrower. If a borrower’s credit rating falls, then the price of its bonds will also fall.

Demand for Australian government bonds can rise when equity markets are falling, as they are considered to have lower credit risk than corporate bonds. However, fixed rate government bond prices remain sensitive to changes in market interest rates.

Table: Summary of differences between FRNs and government bonds

Example of how FRNs work

The example below indicates how income from a FRN is derived. FRNs are commonly issued by financial institutions in Australia, including the one described below.

• The Commonwealth Bank of Australia issued a senior floating rate bond on 9 July 2026 with a maturity date of 9 July 2031.           
• The interest rate is set at 3-month BBSW plus a fixed margin of 0.67%.           
• The bond was issued for five years and pays quarterly interest.            
• On the very first day of issue, investors outlaid $100 per bond. The 3-month BBSW rate is taken that day and added to the fixed margin of 0.67% to determine the interest rate applicable for the coming quarter.                    
• The coupon rate for a quarter is calculated at the time the interest is paid for the previous quarter.         

The last payment to investors on 9 July 2031 will be the $100 face value of the bonds plus interest for the final quarter.                  

FRNs offer investors several key benefits:

• Potential protection against rising rates: The prices of FRNs tend to be less sensitive to interest rate movements than fixed rate bonds because coupon payments reset regularly.
• Income that adjusts with short-term interest rates: FRN coupons typically reset quarterly at a fixed margin above a reference rate, such as the bank bill swap rate. This allows income to rise when the reference rate increases, although income also falls when it declines.
• Portfolio diversification: FRNs can provide a different risk-return profile that diversifies risk taken on by investing in equities, alternatives and other fixed income holdings.

The challenge for most retail investors, however, is that many FRNs trade over the counter and require large minimum investments. An ETF makes it easier to access a diversified portfolio through a single ASX trade.

The VanEck Australian Floating Rate ETF (FLOT) invests in a portfolio of investment-grade Australian dollar-denominated FRNs. The fund pays out dividends monthly.  

Key risks

An investment in our floating rate bond ETF carries risks associated with: bond markets generally, interest rate movements, issuer default, credit ratings, fund operations, liquidity and tracking an index. See the VanEck Australian Floating Rate ETF PDS and TMD for more details.

FLOT is likely to be appropriate for a consumer who is seeking capital preservation and a regular income distribution, is intending to use the product as a core, minor or satellite allocation within a portfolio, has an investment timeframe of at least 3 years, and has a medium risk/return profile.