Floating Rate Notes in High Rate Environment and the Stock Market Response

Abstract

Previous study finds that the firms with inferior growth options tend to issue callable bonds. Typically, these firms are characterized by stock underperformance. Previous study also finds that the floating rate as a superior alternative to the call provision, which is restrictive, when the interest rates are likely to fall. We study the long-term stock performance of floating rate notes (FRNs) issuing firms, issued when the interest rates are high. Stock overperformance would suggest floating rate as a preferred choice by the firms with high growth options rather the call option. We find that the FRNs are generally investment grade with extremely rare presence of a call option. We perform the analysis using Buy and hold abnormal return (BHAR) as the proxy for the long-term stock overperformance/underperformance. A sample of floating rate notes issued (1654) from 1992 to 2007, a period of high interest rates, reveals significant overperformance by the floating rate notes issuing firms in the high-rate paradigm. High growth firms, in the high-rate environment, significantly benefit from the floating rate provision which is less restrictive and less costly than the call option, which typically provides call protection period and pays a call premium. Floating rate provision better mitigates the interest rate risk for the firms in the high-rate environment. We find that the smaller, high growth, higher leverage, less profitable firms with greater agency issues benefit more from issuing FRNs in the high-rate environment. Our study has relevance to the stock portfolio construction and performance. We also perform a comparative analysis using the sample of floating rate notes issued (270) during 2008 to 2018, a period of low interest rates, and find stock underperformance. The implications are that the call option likely is a better choice for the firm since the firm preserves the right to forego exercising the option.