Floating-rate notes

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Floating, not fixed, Mr Bond. Sales of corporate bonds carrying a variable rate of interest are on track to set records in the US, eurozone and UK markets. Based on the year so far, more than half the $900bn of dollar-denominated investment grade corporate bonds projected to be sold in 2006 could be floating-rate notes (FRNs) – up from as little as 25 per cent in 2001. In the larger euro market, the proportion is heading towards 80 per cent, compared with less than 60 per cent five years ago.

There is one obvious explanation. When interest rates rise, the value of fixed-rate bonds declines. FRNs are immune to this kind of investment loss, and their popularity accelerated well in advance of rate increases that began in the US in 2004 and in Europe last year. With US rates approaching a peak and strong institutional demand for long-dated fixed income assets – from pension funds, for example – a shift back towards fixed-rate bonds seems likely.

But other factors could help keep FRN issuance going. In recent years, insurance companies and other new buyers have emerged and investors have become more international. That should bolster demand, especially for dollar-denominated paper in which European investors, who have greater appetite for floaters, are more and more active. In addition, although financial groups traditionally dominate floating issuance, non-financials are now including FRNs in financing packages to help attract the widest possible range of buyers. Xerox, for instance, this month added $150m in floating-rate paper to a fixed-rate bond sale. Issuers can easily and cheaply swap a floating-rate liability for a fixed one.

Another twist comes courtesy of the increasingly influential credit derivatives market. To sniff out relative value between bonds and credit default swaps, sophisticated investors and traders have to find an apples-to-apples comparison. That means analysing bond returns against Libor, the floating-rate benchmark, rather than against government bond yields. Over time, this growing Libor-savviness could mean more floating-rate notes in the market mix.

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