MOST investors are familiar with standard fixed income investments which bear either a fixed or variable interest rate. However, frequently overlooked are instruments structured with a rate that is fixed for a given period of time and floating for the remainder of the tenor. In an effort to broaden our investment horizon let’s take a closer look at fixed-to-floating rate bonds.

As the name suggests, a fixed-to-floating rate instrument starts out with a fixed coupon, which then becomes variable after a given period of time. A fixed rate bond returns a specific coupon each payment period. In contrast, the coupon on a floating rate bond is variable and is usually determined according to established parameters. Most floating rate coupons are structured as a spread above a given base interest rate such as LIBOR (the London Inter-bank Offered Rate). The fixed to floating instrument combines these two structures by specifying a period of time during which the coupon is fixed, and a period of time during which the coupon is variable.

The pros and cons

Fixed-rate coupons provide a guaranteed stream of income over the life of the security. This guarantee and the ability to predict your future cash flow are not as robust with variable rates. Nevertheless, the primary advantage of variable rates is the fact that they allow the investor to capitalise on rising interest rates. It must be emphasized that the uncertainty inherent in a variable coupon is mitigated by the parameters that define the rate. A higher spread and restrictive covenants ensure that bondholders are adequately compensated for the risk they assume. In stable macroeconomic environments and growing economies the uncertainty and risk of rate decline associated with variable coupons are significantly lower. As such, fixed to floating bonds issued by investment grade corporations and Governments provide attractive ways for conservative risk appetites to take advantage of variations in market conditions.

Bonds structured with fixed to floating rates tend to have long or perpetual maturities. These long tenors are intended to span a variety of changes in the interest rate environment. The fixed rate period of investment is intended to span low interest rate environments and allow investors to maintain an attractive return on their investments. The variable rate period is structured to span a rising interest rate environment, thereby protecting the investor against a fall in the value of his fixed income securities

Why fixed to floaters are good in the present environment:

Interest rates are at historical lows, in Jamaica as well as in the global markets. It is fair to conclude that interest rates can only rise with the improvement in the global economy. As interest rates rise, so will the base rate upon which your floating coupon is calculated. This results in an increase in the variable rate your investment attracts. This is an ideal environment in which to consider a fixed to floating rate instrument.

There are several considerations which should go into selecting a particular bond from among those that are available in the international marketplace. The actual fixed and floating coupons that the bond offers, the credit quality of the issuer and the call date on which the coupon switches from fixed to floating are all important factors. A knowledgeable and informed investment advisor can help select the bond that best meets the particular needs of each investor.

Whether you like the security of a fixed rate or the potential gain of a variable rate, it’s a great time to consider a fixed-floating bond for your portfolio.

Dian Blackwood is a personal financial planner with Sterling Asset Management Ltd. Sterling provides medium to long term financial advice and instruments in US and other world market currencies to the corporate, individual and institutional investor.

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