FRN or Fixed coupon with duration hedging?

FRN or Fixed coupon with duration hedging?

EUR FRN vs FIX The notional outstanding in EUR Fixed coupon vs FRN is 7.3:1 Years to maturity The ratio is 23:1 in 5+ yr segment ( 872bn fix vs 38bn FRN outstanding). Source: Bloomberg, own calculations. We use a data set of all 500mn (benchmark size) issues in EUR corporates/finns trading at non-distressed levels (inside 1000bp in z or DM). The FRN sample is 223n, and the fixed sample is 1,630bn. Chart is cut off at [-100,500] in spread and [0,10] years in remaining maturity.

Z-spread / DM margin USD FRN vs FIX The notional outstanding in USD Fixed coupon vs FRN is 23:1 The ratio is 69:1 in 5+ yr segment (2.76tn vs 40bn outstanding). Source: Bloomberg, own calculations. We use a data set of all $500mn (benchmark size) issues in USD corporates/finns trading at non-distressed levels (inside 1000bp in z or DM). The FRN sample is $199bn, and the fixed sample is $4,683bn. Chart is cut off at [-100,500] in spread and [0,15] years in remaining maturity.

USD FRN vs FIX The notional outstanding in SEK Fixed coupon vs FRN is 1:1.9 The ratio is 1:1.55 in 5+ yr segment (SEK29.5 vs SEK46bn outstanding). Note that a fair amount of SEK denominated AT1 have been issued in FRN format (SEK 4.9bn). High spread bonds as those are usually not duration hedged due to low intererest rate sensititivty. Source: Bloomberg, own calculations. We use a data set of all SEK200mn issues in SEK corporates/finns.the FRN sample is SEK336bn, and the fixed sample is SEK176bn. Chart is cut off at [-100,500] in spread and [0,15] years in remaining maturity.

Why is it so important to be able to take on long-end spread in credit? Tennet 1.875 36s, Jun-Aug 2016 (2 months) Verizon $6.55 432, Sep-Dec 2013 (3 months) +15% + carry +20% + carry The added duration in long-end bonds make some of the trades we have done over the years mathematically near impossible to have achieve in FRN format. Trades like the Tennets and the Verizon above generated 15-20% returns over a few months, with over 75% of the P&L generated from credit spread compression rather than government yields falling. Unless global issuance patterns change dramatically, there will be very little supply of long-end spread paper within the foreseeable future. Nothing should be set in stone, of course. We should be able to go into FRN format when attractive, but setting it as a strategy to handle interest rate duration will make a credit book miss out on very large alpha opportunities.

Diversification and liquidity Currently, 75% of outstanding FRNs are in the financials sector, across currencies. There is not that much dis-similarity in the sector distribution between Fix and FRN in SEK but note that Financials also include the real-estate sector, which is a large issuing sector in SEK. However, one could argue that realestate companies, essentially holding long duration assets, have a direct transmission of rate risk into the business model, hence making real-estate FRNs indirectly rates sensitive. => Very hard to diversify out of the Financials sector using only FRNs. => Liquidity will be worse in smaller segments of the market.

Trade economics when in the cycle do FRNs make most economic sense? The break-even rates for FRNs to be as attractive as holding a fixed coupon bond (no duration hedge) depends on how steep the rate curve is. The FRN holder bets on rates going up more than the roll-down on the rate curve. A simple example: we have a four year bond in fix and floating format. For simplicity, we assume that duration equals maturity, and that the spread curves of the bonds are identical as well. In year one, without a rate rise, the fixed bond rolls down from 2.8% in yield to 2.5% = 30bp of roll-down. This gives a total return of 0.3%*4 + 2.8% = 4%. How much do rates have to rise for the total return to be zero in year one? They have to rise 4%/4yrs = 1%, ie. to 3.5% at the 4 year point. Now, contrast this the case of an inverted yield curve, where we roll up from 2% to 2.1% between the 5yr and the 4yr, meaning a total return of 1.6%. In the inverted case, interest rates only have to go up 0.4% for the FRN to break even. Hence, flatter/more inverted curves make FRNs more economically attractive as break-evens are much lower. Lower breakevens make them more attractive for funds that have difficulties to otherwise short duration, as they pay less negative carry on holding FRNs vs holding fixed coupon bonds. When are curves flat/inverted? This is a classical macro-economic indicator, illustrated in the bottom graph with ellipses. As can be clearly seen, inverted curves are a good warning signal for a coming recession. Recessionary environments are typically ones where rates go down, liquidity premiums go up, short term credit spreads underperform (flatter credit curves), all of which are factors that are detrimental to FRNs as an investment case.