What is Floater?
A floater, also known as a floating rate note (FRN), is a bond or other type of debt instrument whose interest payment is variable and tied to a predetermined benchmark index, such as London Inter-bank Offer Rate (LIBOR), that adjusts to current market conditions.
A floater lies may be contrasted with a fixed-rate note, which pays the same interest rate for its entire maturity.
- A floater is a debt instrument whose interest rate is tied to a benchmark index such as LIBOR, which is known as its reference rate.
- A floater protects investors from rising interest rates because it allows them to reap the higher yields when the coupon rate is adjusted higher.
- Most floaters have both a cap and a floor, which allows an investor to know the maximum and/or minimum interest rate the note will pay.
A floater is a fixed income security that makes coupon payments based off of a reference rate. The coupon payments are adjusted following changes in the prevailing market interest rates. When interest rates rise, the value of the coupons is increased to reflect the higher rate. Other reference or benchmark rates include the Euro Inter-bank Offer Rate (EURIBOR), federal funds rate, and US Treasury rates. For example, a floater bond may have the coupon rate set at "3-month T-bill rate plus 0.5%". A government or corporate issuer may pay coupons on a floater monthly, quarterly, semi-annually, or annually.
Since floaters are based on short-term interest rates, which are generally lower than long-term interest rates, a floater typically pays lower interest than a comparable fixed-rate note of the same maturity. If the perception of the creditworthiness of the issuer turns negative, investors may demand a higher interest rate at, say 3-month T-bill rate plus 0.75%.
A floater is more beneficial to the holder as interest rates are rising because it allows a bondholder to participate in the upward movement in rates since the coupon rate of the bond will be adjusted upwards. Investors, who choose floaters, are willing to accept a lower initial rate in exchange for the possibility of a higher rate if market rates rise. The unpredictability of the coupon rates is the main reason that floaters carry lower yields than fixed rate notes of the same maturity. Conversely, a floater is less advantageous to the holder when rates are decreasing because the payments they receive may be lower than the fixed rate they could have had.
Most floaters will come with both a ceiling (cap) and a floor, which allows an investor to know the maximum and/or minimum interest rate the note will pay. A cap is the maximum interest rate that the note can pay, regardless of how high the benchmark rate climbs, and protects the issuer from escalating interest rates.
A floor, in comparison, is the lowest allowable payment and protects the investor from a severe decline in interest rates. A floater’s interest rate can change as often or as frequently as the issuer chooses, from once a day to once a year. This is intended to protect investors from falling interest rates.
Floaters will also have a reset period, which tells the investor how often the rate adjusts. For instance, many floaters adjust on an annual, semi-annual, or quarterly basis.
One type of floater that may be issued is called the inverse floater. The coupon rate on an inverse floater varies inversely with the benchmark interest rate. The coupon rate is calculated by subtracting the reference interest rate from a constant on every coupon date. When the reference rate goes up, the coupon rate will go down since the rate is deducted from the coupon payment.
A higher interest rate means more is deducted, thus, less is paid to the debt holder. Similarly, as interest rates fall, the coupon rate increases because less is taken off. To prevent a situation whereby the coupon rate on the inverse floater falls below zero, a restriction or floor is placed on the coupons after adjustment. Typically, this floor is set at zero.