Almost every investor sometimes faces the problem of cash sitting on is account. In the low-interest environment, it is always a problem. You do not want to hurry your stock investment decision, sometimes you have to wait for entry point longer. Sometimes, you do not feel comfortable to invest at the market highs and are waiting for a substantial correction.
We are in a period of rising interest rates. There is no doubt about it. Nevertheless, there are plenty of people who doubt that share prices will rise forever and are afraid of fall. Therefore, there is a legitimate question what to do with your cash you keep for investing in future. And how to keep earning on rising interest rates in the defensive and risk-averse way.
As a result, investors either tend to leave their funds in cash or place some of the funds in deposits in banks.
According to Cap Gemini’s World Wealth Report, the average high-net-worth household is holding at the end of June 2017 more than 23% of its assets in cash (source: wealthmanagement.com, semi-annual review 15.08.2017).
Why investors can benefit from floating rate notes. or FRNs
Floating Rate Notes (FRN) could be the answer. A floating rate note is a debt security with a variable interest payment. The interest rate usually references an interest rate benchmark, such as Libor. As interest rates rise, the security’s interest payments are expected to increase, so its yield increases. Conversely, FRN interest payments decrease as interest rates fall. Consequently, The FRN have become quite popular in recent years and represent nowadays between 10% to 25% of the asset allocation in a fixed-income portfolio.
Would it make sense replacing deposits by FRNs?
Well, the answer is yes.
We requested a quote earlier today from Bank Hapoalim for a USD 12-month deposit. We received an offer at 1.69%.
As an alternative, an FRN emitted by Goldman Sachs that offers a yield linked to the 3 month floating rate with an additional margin of 1.75% is currently traded with a yield 2.50%.
Besides the obvious difference in yields, you should take into account the following:
- You are protected against a rise in interest rate thanks to coupon resets that occurs on a quarterly basis.
- The issuer (Goldman Sachs) has a high rating (Fitch’s rating: A) as most banks in Israel. Therefore, instead of placing all funds in your local bank (bank Hapoalim for example), you could minimize the credit risk by choosing several FRNs with such a rating instead of placing all the funds in the same bucket.
- Also, FRNs are tradable which means they can be sold on a daily basis. Comparing it to deposits that you cannot break easily (and without losing the interest), the FRNs are probably most suitable if you have no visibility when you expect to use the funds.
What are the costs associated when purchasing an FRNs?
When investing in FRNs, as any other tradable security, local banks charge generally up to 0.10% – 0.20% for buying or selling the security, depending on the conditions you agreed on with your bank.
In Israel, banks generally do not charge any additional custody fee (which is not the case in most International banks).
You can invest just small amounts in certain FRNs such as the mentioned above Goldman Sachs FRN (minimum USD 2’000). Nevertheless, keep in mind the banks might charge you additional fees for such transactions.
We are confident that investing in Floating Rate Notes is a good alternative if you want to participate on rising interest rates. It will enable you to focus on capital preservation and maintaining liquidity in the same time.
The views and strategies described herein may not be suitable for all investors. This information is not intended as an offer or solicitation for the purchase or sale of any financial instrument and is being provided merely to illustrate a particular investment strategy.