Fairway Bond

What Is a Fairway Bond?

A fairway bond has a floating interest rate or an interest rate option that underlies the bond, which pays interest when the embedded index or underlying interest rate option remains within a specified range. The value of a fairway bond is at its maximum when the interest rate the bond is indexed to remains within its pre-set channel over the bond's life.

A fairway bond can also be referred to by several other names, including corridor bond, index range note, range accrual note, and index floater.

Key Takeaways

  • A fairway bond is a type of bond that pays interest when its embedded index or underlying interest rate option stays within a pre-specified range.
  • Fairway bonds are often preferred by conservative investors and typically carry a short-term floating interest.
  • Investors often opt for fairway bonds when interest rates are expected to rise, but only slightly, in the near future.
  • It is called a "fairway" bond because the index channel is akin to the fairway on a golf course: the sweet spot.
  • Fairway bonds also go by several other names, including corridor bonds, index range notes, and range accrual notes.

Understanding Fairway Bonds

As long as the fairway bond’s rate stays within the specified range, the bond is said to be in the fairway, a golf metaphor meaning securely in play. If the bond’s yield falls out of its prescribed range, it is said to be in the rough.

The outlook for a bond, similar to a golf shot, is considered positive if it lands in the fairway, but the outlook is negative if it lands in the rough.

Benefits of a Fairway Bond

Fairway bonds are often preferred by conservative investors, who choose the securities in the hopes of maximizing their yield when they believe that the option will remain within a certain range during the time period when the bonds are held. Investors in fairway bonds may profit the most during a sideways market, which occurs when the price of a given security trades within a range without forming any distinct up or downtrends.

Fairway bonds can also be a popular choice among investors when interest rates are expected to rise in the near future. Many investors tend to shy away from the bond market during periods of potentially higher interest rates because they don’t want to be locked into the current lower coupons if rates do move higher. However, investors in fairway bonds can take advantage of higher interest rates as they occur by purchasing bonds whose rate will remain in or land in the predetermined range even if the expected hike is included.

At worst, even if a fairway bond’s embedded index or interest rate option remains out of range, or in "the rough," for the life of the security, an investor can still expect a return of the bond’s principal upon its maturity.

Floating Interest Rate vs. Interest Rate Option

Fairway bonds typically carry a short-term floating interest or an interest rate option. A floating interest rate moves up and down with the rest of the market or along with an index. It can also be referred to as a variable interest rate because it can vary over the duration of the debt obligation. This is why fairway bonds are also commonly known as index floaters.

An interest rate option is a financial derivative that allows the holder to benefit from changes in interest rates. It is similar to an equity option and can be either a put or a call. Typically, the movement follows an underlying benchmark rate, such as the yield on the 10-year Treasury note.

When Should I Buy a Floating Rate Note?

A floating rate note (FRN), or "floater" is useful for investors to take advantage of rising interest rates in the near-term.

When Should I Buy a Fairway Bond?

A fairway bond has some features similar to a FRN, but is bounded by a pre-set range in the movements of the underlying interest rate index. As a result, a fairway bond is best-suited to an investor who believes that interest rates will remain relatively stable over the maturity of the bond.

Is a Fairway Bond a Loan?

All bonds are debt instruments, including fairway bonds and other floating rate notes. As a result, the issuer of the bond is, in effect, receiving a loan from bondholders (who become the creditors).