Floating Rate Notes
November 4, 2013 | By Hank Cunningham
Floating Rate Notes (FRNs) have become popular of late. They are generally issued with relatively short maturities, paying interest monthly or quarterly. For each interest period, the coupon rate is set at a specific spread over an index of Canadian Bankers’ Acceptances known as the Canadian Dealer Offered Rate (CDOR).
Thus far in 2013, there have been a total of $69 billion of FRNs issued by Canadian borrowers in both U.S. and Canadian dollars.1 Typically issued by provinces, banks, and crown corporations, the recent popularity of FRNs has attracted many other corporate entities to the market.
The cause for this surge in FRN issuances can be traced to the dramatic selloff in the bond market, which began this April. This spooked investors and they sought securities that would protect them from price declines brought on by increasing yields. FRNs gained traction as they purported to offer yields that would move higher at each reset period.
The problem is that yields are not rising in the money market. A typical FRN pays interest quarterly at a spread over the three-month CDOR. As the chart below displays, CDOR has been unchanged since last June and, based on recent statements from both the U.S. Federal Reserve Board and the Bank of Canada, it is highly unlikely that administered interest rates will change for at least two more years.
1Source: Thomson Reuters
What then, is the appeal of FRNs?
Firstly, they offer principal protection. Because of the quarterly reset, their coupon rate will be close to market yields and their market price will show little fluctuation. However, they have little or no upside if interest rates don’t rise, so what an investor has in essence is a money market alternative.
Secondly, there are also credit concerns with some FRNs. Chartered banks issue them regularly (see example below), but so do many other lesser-rated corporations. Thus, credit risk is another consideration when investing in an FRN.
Finally, they also bear price risk in extraordinary times; we witnessed the dramatic price decline of many FRNs and ETFs during the 2007/08 meltdown.
Bank of Montreal FRN January 9, 2015
Current coupon: 1.595%
Market Price: $100.25 equal to an effective return of 11 basis points over CDOR
Reset terms: CDOR plus 32 basis points adjusted quarterly
We are comfortable with FRNs as long as:
1) They are of the best credit quality;
2) Investors realize that their returns will not exceed the current low yield until CDOR begins to rise; and
3) They are being considered as a money market alternative.
However, we do not advocate their use as part of the fixed income portion of one’s portfolio. Investors will achieve greater returns by investing in a combination of one to three year GICs and by rolling down the yield curve by using four and five year investment grade corporate bonds.
The Bursting of the Complacency Bubble
June 20, 2013 | By Hank Cunningham
The rout in the U.S. Treasury bond market has shaken global markets. Bond funds are experiencing massive redemptions, totaling some $50 billion in U.S. mutual funds so far. Most of the redemptions are occurring in high yield bonds and bond funds, emerging market bond funds and intermediate term investment grade bond funds and bonds. In Canada, related markets such as REITS and preferred shares are also taking a big hit.
For the last three years, fixed income investors have become complacent with high yield bonds and emerging market bonds, becoming comfortable with the extra yields they provided along with double digit returns. The so-called “carry trade” has also been shaken. Traders were content to borrow cheap U.S. dollars at close to zero per cent and invest the proceeds anywhere that yields were higher, which meant almost anything: high yield bonds, emerging market bonds, Eurozone bonds and so on. They are now liquidating their positions.
It now appears that Apple caught the lows in corporate bond yields for this cycle in April. This has been a borrower’s market and hit its peak on April 30. That day, Apple issued $4 billion 1 per cent bonds due May 3, 2018 and $5.5 billion 2.45 per cent bonds due May 3, 2023. They are 3 and 7 points lower respectively since then.
Fixed income investors had become accustomed to years of near double digit returns from their bond portfolios and now they are facing “sticker shock” as returns for May were negative and they likely will be in June as well. The DEX Bond Universe is minus 2.41 per cent thus far in June and minus 2.07 per cent year-to-date. Corporate bonds are down by a similar amount this month and down 0.6% for the year-to-date.
It is likely that further redemptions and selling of bond funds and bonds will take place once June’s returns reach investors. Forced selling by ETFs could also add to market woes as, in the absence of new inflows and facing redemptions, ETFs will have to sell bonds in a weak market, possibly exacerbating the weakness.
The easy ride in bonds is over and returns, if any, will be modest. What is happening is that bond yields, after being abnormally low for an extended time, are beginning to normalize. The cost of money remains inexpensive for borrowers which is another way of saying that they are expensive for investors. We are witnessing a rise in real yields from levels which were negative for a while and barely positive earlier this year.
Those investors who have maintained their ladders have done well and should continue to do so as maturing bonds may be re-invested at progressively higher yields.
Rolling down the yield curve by investing in four and five year investment grade corporate bonds remains an attractive option as the yield curve will likely remain steep for the next two years.
Thus, short duration portfolios of investment grade corporate bonds remain the preferred choice.
Rolling Down the Yield Curve
May 7, 2013 | By Hank Cunningham
The advantage of buying corporate bonds in the four to six year term has to do with three factors:
1. As time goes on, they move closer to maturity and thus offer less risk to principal.
2. As they move closer to maturity, the spread from the underlying Canada benchmark bonds narrow. Looking at this another way, corporate bond yield spreads widen from the government curve since credit risk increases as maturities lengthen.
3. In a positive yield curve environment, the yield on the bonds would fall if the yield curve remained unchanged or shifted lower. Even if the yield curve moved higher, there would still be a relative gain since the upward slope of the curve means that each shorter maturity would yield less than the previous maturity.
This advantage can be more clearly explained by looking at the following two tables. The first shows the Canada Yield Curve and the second depicts the yield spread over the Canada Yield Curve by two prominent borrowers:
|Canada Yield Curve |
|3-Year ||5-Year ||7-Year ||10-Year |
|1.09% ||1.28% ||1.52% ||1.82% |
| ||Corporate Spreads (Basis Points) |
| ||3-Year ||5-Year ||7-Year ||10-Year |
|BMO ||73 ||93 ||108 ||123 |
|Bell Canada ||80 ||105 ||123 ||145 |
Thus, one could buy a 7-year Bell Issue at a yield of 2.75% (1.52+1.23).
Two years later, this bond would yield 2.33% (1.28+1.05) for a gain of 42 basis points (24 from the yield curve slope and 18 from the narrower credit spread).
This helps to explain why corporate bonds have performed so well in the past few years. The bond market is not a perfect world; the yield curve changes its slope continually while corporate spreads narrow and widen over a credit cycle.
Nevertheless, investing in four to six year corporates can contribute to positive performance.
Is The Honeymoon Ending?
April 26, 2013 | By Hank Cunningham
The love affair for Canadian investors and bond mutual funds continued in the first quarter of 2013, but as is evident, at a sharply reduced pace. More interesting is that after several years of net redemptions, equity mutual funds are enjoying net sales now.
The money for these net purchases of bond and equity mutual funds is coming from money market redemptions and this is a healthy development.
While it is too early to label this the beginning of the so-called “rotation” out of bonds into equities, it is a promising beginning.
Run For The Hills
April 5, 2013 | By Hank Cunningham
Canada has the shortest weighted average maturity of bonds in the Group of Seven at 5.1 years. The overall yield on its debt is a meager 1.51 per cent.
According to Finance Minister Jim Flaherty, the Government plans to cut its reliance on money markets and will boost the issuance of 10 year bonds. It will hold five auctions of the 10-year bond plus three of the 30-year bond this fiscal year. The goal over the next decade is to have 10-year bonds amount to 50% of market debt and for 30-year bonds to total 29 per cent.
Further, and I note with considerable bemusement, the Finance Minister is toying with the concept of issuing “ultra-long” bonds with a 40-year maturity. Other sovereign nations have already done this as have a few of our provinces, issuing bonds with terms of 50-years. Mexico issued a 100-year bond actually!
It is easy to identify who the buyers are. Pension Funds and life insurance companies everywhere are seeking the longest duration securities to offset growing long-term liabilities.
In so doing, they are overlooking the best long duration asset category: investment grade, dividend paying equities.
The longest maturity Canada bond, the 3.5 per cent December 1, 2045 has a duration of 20.6 years. If the Federal Government issued a 2053 maturity tomorrow, its duration would be just 21.8 years.
Returning to the real reason why Flaherty would like to extend the average term of our debt is the following: Money is cheap so why not lock in these historically low yields?
I agree with the Government’s approach; this could be a long term win for Canadians.
However, investors should head for the hills and keep short duration corporates in their portfolios.
Ringing in Purple Day
March 26, 2013 | By Hank Cunningham
As the Chairman and CEO of Care-Alive (The Caroline Cunningham Foundation for Epilepsy), I had the privilege of opening the Toronto Stock Exchange with Olympic gold medalist Rosannagh MacLennan and the team at Care-Alive™ to commemorate Purple Day today. + View Video
Purple Day raises awareness for epilepsy and March is epilepsy month. Founded in 2009, Care-Alive™ aims to care for those living with epilepsy by providing support for individuals and their families. Visit www.care-alive.com for more information.
OLYMPIC GOLD MEDALIST ROSANNAGH (ROSIE) MACLENNAN OPENS TSX WITH CARE-ALIVE ON TUESDAY, MARCH 26
March 25, 2013 | By Hank Cunningham
Care-Alive™ - The Caroline Cunningham Foundation for Epilepsy - will be joined by Canadian Olympic Gold Medalist Rosie MacLennan as we open the TSX on March 26th for Purple Day. Purple Day is the Global Day of Epilepsy Awareness. This will mark Care-Alive’s third time opening the TSX and we’re thrilled to have Rosie with us. Learn more
March 19, 2013 | By Hank Cunningham
Welcome to the first entry in Hank’s Blog.
Here, you will find links to my BNN appearances, media articles in which I have been featured or quoted, or other topics of interest.
As Odlum Brown’s Fixed Income Strategist, I hope you will find my views on the credit market, bond market and the economy insightful.