Liquidity Lowdown: the case for floating rate securities

For years, central bank policy has been one of the main determinants of money market pricing, and yield curves have generally reflected a market consensus on the likely path of interest rates. Markets have, at times, priced in as many as three rate hikes this year, even though few economists have genuinely expected such an outcome. So what does this money market curve steepening reflect if not the actual path of rate expectations?

Investors appear to be demanding additional compensation simply because the future has become harder to predict.

The Bank of England (BoE) continues to balance slowing economic growth – barely expected to surpass 1% in 2027 – against inflation that remains vulnerable to external shocks. Energy prices and ongoing geopolitical tensions have both contributed to the uncertainty surrounding the inflation outlook, which has risk skewed to the upside. In other words, the curve may be reflecting a higher uncertainty premium, rather than a strong conviction that rates are genuinely heading higher. Investors appear to be demanding additional compensation simply because the future has become harder to predict. This may lead investors to conclude that fixed-rate instruments are naturally more attractive than their floating-rate counterparts, but we do not believe the picture is quite that straightforward.

The case for floating rate securities

A steeper money market curve can create some obvious opportunities. By investing in longer-dated assets, investors can lock in attractive returns, but the challenge is that many of the same factors causing curve steepening also create risks that rates ultimately move higher than policymakers intend. This leads to the scenario where the benefit from higher yields is partially offset by mark-to-market risks if rate expectations continue moving upwards.

While markets were once convinced that inflation was heading lower, the path for future inflation is less certain and floating rate securities protect against this uncertainty.

Many investors focus on the additional carry generated from a fixed rate instrument when they feel that market pricing is more hawkish than their own expectations. However floating rate securities can offer protection against upside inflation surprises. The UK has already experienced higher energy and oil related pressures, and while the conflict in the Middle East has not delivered the broad inflation shock that we saw in 2022, we remain cautious about rates remaining higher for longer. While markets were once convinced that inflation was heading lower, the path for future inflation is less certain and floating rate securities protect against this uncertainty.

Floating rate securities can also offer attractive yield premiums over the sterling overnight index average (SONIA). The spreads on floating rate certificates of deposit (FRCDs) are currently near their historic highs, allowing a fund to earn interest from credit risk while minimising duration risk. One-year FRCDs are currently achieving yields more than 38 basis points over SONIA, with a coupon that resets daily. While the spread over SONIA remains fixed for the duration of the trade, SONIA itself fluctuates in line with the Bank of England base rate. As a result, if the base rate falls, the return generated by the FRCD will also fall. However, FRCDs can help maintain returns linked to cash rates, which support the overall objective of the fund. Ultimately, we believe a money market portfolio positioned to delivering consistent outcomes across a variety of economic scenarios is more likely to achieve better long-term performance and stability than one that is trying to predict every market move.

For professional investors only. This material is not suitable for a retail audience. Capital at risk. This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.