How do I manage a floating-rate note portfolio for interest rate and credit risk?

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AcadiFi · Accepted Answer

Floating-rate notes (FRNs) have minimal rate duration (typically 0.1-0.3 years) but meaningful spread duration and credit risk. Design considerations. Reset mechanism: SOFR + spread, typically SOFR + 40-150 bps for investment-grade corporate FRNs, 200-500 bps for HY. Reset frequency quarterly means duration to SOFR ≈ 0.25 years maximum between resets. Spread duration however equals time to maturity; a 5-year FRN has spread duration ~4.8 years because credit spreads don't reset. Portfolio construction for Hazelmere Short Duration Fund $400M. Allocate: 70% IG corporate FRNs (financials and industrials, laddered 2-5 year maturities), 15% AAA CLO tranches (SOFR + 130-180 bps), 10% agency FRNs (lower yield, high quality), 5% cash buffer. Yield pickup versus 3M T-bills roughly 80-150 bps at average credit quality A+. Key risks. First, credit spread widening. In a 2020-style risk-off, IG corporate spreads can widen 150 bps, driving mark-to-market losses of roughly 150 bps × 4 year SD = 6% even though rates are flat. Second, issuer-specific credit. Diversify to 100+ issuers with per-name caps (1-2%). Third, CLO tranche risk. AAA CLOs survived 2008-09 and COVID without loss but trade on wider spread; monitor underlying CLO manager and deal performance. Fourth, liquidity. FRNs trade thinner than fixed-rate bonds; bid-ask 10-30 bps. Fifth, back-end spread risk: after a few years, FRN trades closer to par but spread may reprice at refinance. Rebalancing: monitor spread duration monthly, rate duration daily. Use TRS on the IG CDX to hedge tail credit risk ($40M notional short hedges roughly 25% of spread DV01). Expected return over SOFR: 80-120 bps net in normal markets.

How do I manage a floating-rate note portfolio for interest rate and credit risk?

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