Article 4.6 Floating rate bond issuance jumps in Europe

By Christopher Thompson and Ralph Atkins

Financial Times August 29, 2013

European companies have switched to issuing debt at variable interest rates as investors fret about higher global borrowing costs.

The proportion of European corporate bonds issued in August as ‘floating rate notes' has more than doubled month-on-month to nearly a fifth of overall issuance. Overall European companies have issued $25bn of floating rate bonds for the year to date, the highest total since $42.4bn achieved in 2007 over the same period.

Global issuance has spiked to $96bn from $52bn last year.

The rise in US Treasury yields has led to a marked slowdown in overall corporate bond issuance recently as companies ponder the implications of longer-term higher costs.

The switch to floating rate notes is part of the same trend.

‘Companies are simply tapping into the market which is hottest with investors, given the widespread worry about rising rates,' said Matt King, at Citigroup.

‘If rates were to rise, it would be a negative for those companies concerned... but bank loans they had previously would have been floating-rate, and many issuers traditionally swap fixed-rate bond issuance back into floating, so the impact should be no worse than it would have been anyway.'

Shrinking bank lending has pushed many companies to seek more funding from the public bond markets as European companies move towards a more US-style market based model of corporate finance.

European non-financial corporate issuance rose nearly 20% in the first half of this year to $333bn as companies took advantage of historically low interest rates.

As longer term borrowing costs rise, Europe's banks are also turning to bonds with floating interest rates.

While their issuance dipped to $3.2bn in June it rose to $6.2bn in July and stands at $6.7bn so far this month, according to Dealogic.

That followed comments by Ben Bernanke, chairman of the US Federal Reserve, about the prospect of tapering the Fed's asset purchasing programme known as quantitative easing.

Global financial institutions' floating rate bond issuance has risen to $182.4bn so far this year from $127.4bn over the same period in 2012.

For banks, which lend at variable interest rates, the issuing of floating rate bonds allows them to better match assets and liabilities.

Source: Thompson, C. and Atkins, R. (2013) Floating rate bond issuance jumps in Europe, Financial Times, 29 August.

FRNs may come with additional features such as a floor, which means that the coupon can fall but there is a minimum beyond which it cannot go, and caps, which permit a rise in the coupon with the underlying benchmark only up to a point, there is a maximum. If there is both a floor and a cap the bond is said to be a collared FRN.

FRNs will trade at par value on each of the coupon reset days. But if interest rates rise between reset days they will trade slightly below par because investors can now obtain the higher rates on alternative bonds and so are less willing to hold the FRNs unless the price falls commensurately. If rates fall then FRNs will trade at slightly above par until the next reset day.

Coupons linked to other variables

Bonds issued in the last few years have linked the interest rates or principal payments to a wide variety of economic events, such as a rise in the price of silver, exchange rate movements, stock market indices, the price of oil, gold, copper - even to the occurrence of an earthquake. These bonds were generally designed to let companies adjust their interest payments to manageable levels in the event of the firm being adversely affected by the changing of some economic variable. For example, a copper mining company, with its interest payments linked to the price of copper, would pay lower interest on its finance if the copper price were to fall.

Callable bonds

The issuer retains the right but not the obligation to redeem these bonds before maturity at a set price which is usually a little more than the par price, say $1,050 instead of $1,000 (the difference is the call premium). In return for this privilege, the bond will pay a higher coupon. If interest rates fall, it would be advantageous for the company to call in its bonds, redeem them and issue new replacement bonds with a lower coupon, thus reducing their cost of borrowing.

European-style callables have a single call date determined at issuance. If the issuer does not call the bonds on that date they become non-callable bonds for the remainder of their term. American-style callable bonds are continuously callable, at any time after the first call date, until the redemption date. Bermudan-style callables have multiple discrete call dates when the bond can be redeemed in whole or in part. Call provisions generally allow for the first five or ten years of the bond's life to be excepted, when the call does not apply (deferred callable bonds), which gives some protection to investors. This lockout period (up to the first call date) has been as short as three months. Freely callable bonds, meanwhile, do not offer the investor any protection against a call because the issuer can call them any time.

For investors the attraction of a higher coupon rate on callable bonds is some­what offset by the risk that, should interest rates fall, the value of a callable bond may also fall or at least fail to rise due to the threat of being called at a low price relative to a similar non-callable bond, contrary to the behaviour of normal bonds where value rises if interest rates fall. This is called price com­pression risk. Callable bonds also suffer from reinvestment risk - see page 133.

Irredeemable (perpetual) bonds

These bonds have no fixed redemption date but ostensibly pay their coupon indefinitely. Many of these bonds have been issued by banks, but non-financial companies also issue perpetual bonds which serve as permanent capital, with some characteristics similar to equity but with the added advantage that in raising money this way there is no dilution of existing shareholders' percent­age share of the company votes - see Article 4.7.