The Benefits and Risks of Investing in Floating Rate Notes
What are Floating Rate Notes?
Floating rate notes are fixed income securities that pay a coupon based on a reference rate that resets periodically. They are typically issued by financial institutions, corporations, and the federal government, with maturities ranging from 2 to 5 years. These instruments can be used to lower the overall duration of an investor’s fixed income portfolio, according to Allison Bonds, head of private wealth management and independent wealth management at State Street’s U.S. SPDR ETF business.
Why Should Investors Consider Floating Rate Notes?
Floating rate notes have a close-to-zero duration, which gives them a measure of relative price stability, while offering investors’ portfolios some support through variable income. Moreover, they can provide an attractive play for some investors, especially with the prospect of higher rates for longer, along with the inverted yield curve.
What are the Risks of Investing in Floating Rate Notes?
In a falling rate environment, floating rate notes may generate lower coupon payments, and total returns may be less than anticipated if future interest rate expectations aren’t met. There is also some concern around reinvestment risk: Once the Fed begins cutting rates, investors could be left without a source of attractive yield if they haven’t locked into a longer-term fixed income asset. Finally, opportunities for price appreciation are also limited.
How Can Investors Invest in Floating Rate Notes?
Investors can invest in floating rate notes through exchange-traded funds (ETFs), which offer more liquidity compared to buying individual issues. It is important to note that the interest generated by floating rate notes is taxed as ordinary income, which has a top marginal rate of 37%. Therefore, these investments are better suited for tax-deferred accounts like individual retirement accounts (IRAs) rather than taxable accounts.
Conclusion
Floating rate notes can be an attractive investment option for investors seeking yield in short-term certificates of deposit and Treasury bills. However, investors should be aware of the risks associated with floating rate notes, such as lower coupon payments in a falling rate environment and limited opportunities for price appreciation. Additionally, the interest generated by floating rate notes is taxed as ordinary income, making them more suitable for tax-deferred accounts like IRAs.
