FRNs as a Source of Liquidity

Many conservative investors operate a strategy of keeping a large percentage of their investment portfolios in term deposits, electing to roll them over every three months or perhaps even more frequently so that they always have a source of ready liquidity through maturing term deposits.  Portfolios are often structured so they have term deposits maturing each week to meet potential cashflow needs.  In a portfolio whose size does not fluctuate wildly, the vast majority of these maturing term deposits simply get re-invested.

At Amicus, we advise our clients to adopt a more sophisticated approach.  If shorter dated term deposit rates are lower than longer dated ones (as they generally are) the approach of unnecessarily rolling too great a volume of shorter dated investments reduces overall portfolio yield. However many Amicus clients place a high value on “peace of mind”, preferring to know they have “liquidity buffers” or “emergency liquidity” available if needed.  Floating Rate Notes (FRNs) provide a far superior source for this type of contingent liquidity as they are easily tradable, with funds provided within two business days of sale which is much more rapid than maturing term deposits.

FRNs have virtually no interest rate risk as their coupons reset every month and credit risk on investment grade FRNs is minimal as the likelihood of a bank actually defaulting is low (and the same risk exists for the the alternative investment of term deposits anyway). FRNs do however carry market risk. This is because prices vary with market conditions meaning the coupon margin on the FRN may be above or below the market trading margin resulting in the FRN’s trading price being above or below the purchase price.  However as outlined below with careful planning and management this can be a benefit rather than a drawback of holding FRNs.

The risk of having to liquidate an FRN in adverse market conditions for liquidity reasons and thus taking a capital loss can be minimised (if not entirely eliminated) through purchasing a portfolio of FRNs and operating a “buy and hold” strategy. A portfolio holding some FRNs will likely be trading above or below the purchase price, so if liquidity is needed the ones that are trading above purchase price can be sold, cash realised and a profit recorded. 

Stacking the odds that FRNs will trade above purchase price in favour of the investor is that all FRNs are subject to what is known as the “roll-down effect”. Unless an issuer is on the brink of default its credit curve is nearly always positive meaning investors demand a higher credit margin for investing in a bond with five years to maturity, more than one with four years to maturity and more than one with three years to maturity, etc.  This means the trading margin naturally reduces as the FRN “rolls down” the maturity curve.

This heavily tilts the odds in the investor’s favour that regardless of market conditions nearly all FRNs will tend to appreciate in price in the years following new issue to reflect their trading margin is now less than their coupon margin due to the “roll down” effect.  This effect is greatest when the FRN is close to maturity and it is very unusual to find any FRN that was originally issued at a five or three year maturity that is not trading at a margin significantly below its issue margin in the last couple of years before it matures.  The exceptions are obviously issuers whose credit-worthiness has deteriorated significantly, but amongst Australian ADIs (AMP perhaps excepted) this is a relatively rare event and can be mitigated by careful selection of the issuer at the point of purchase.

If a portfolio of FRNs has been built up progressively which has a range of issuers and a range of maturities (because some FRNs have been held for a number of years) this will almost certainly provide an effective source of contingent liquidity for any client with the added benefit that any FRN sales if needed will almost certainly also yield a capital profit as well as rapid liquidity.

Amicus has been using this portfolio construction technique with its conservative clients now since it started its advisory business in 2008. Amicus clients who followed our advice now have this “liquidity buffer” in place allowing them to more efficiently allocate more funds beyond short dated term deposits which they previously felt they needed to hold purely for liquidity reasons.

Amicus recently helped one client liquidate half its FRN portfolio to meet a large capital expenditure. This was done efficiently via an auction arranged and run by Amicus.  Please feel free to call us if you would like to discuss FRNs as a potential investment opportunity or if you would simply like to optimise your portfolio construction and asset allocation as these are just a few of the services Amicus offers to its conservative institutional investors clients.

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