Hybrid bonds: The interplay of fixed and floating

FtF bonds are among some of the most challenging fixed income instruments. While most banks tend to develop FtF models in-house, hedge funds trading FtFs may find the implementation challenges too difficult to tackle.

Fixed rates or floating? It’s a question that has been gaining traction in U.S. leveraged credit markets. Since the Fed’s rate hikes, the fixed vs. floating rates debate in U.S. leveraged credit markets has escalated. Floating rates have gained favour post-hikes, impacting hybrid bonds issued by lower-rated companies.

Fixed-to-floating (FtF) bonds represent a special category of bonds where the issuer initially pays a fixed coupon, followed by the option to either redeem the bond at par value or convert into a floating-rate bond. In the latter case, the spread over projection rate can increase, typically every few years. During this floating-rate period, the bond may become callable at pre-specified dates. Given their combination of fixed and floating characteristics, these bonds are commonly referred to as hybrid bonds.

Typically, these bonds are issued by companies with lower credit ratings, aiming to attract investors with the prospect of an increasing spread during the floating-rate period. Even with a relatively higher spread above the floating rate, the issuer will continue to pay bond coupons as long as its credit spread remains substantial. However, if the credit spread diminishes, the issuer is incentivised to redeem the bond and borrow money at a lower cost.

FtF bonds are among some of the most challenging fixed income instruments. They make even simple market calculations such as calculating yield or yield-to-worst much more complex.


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