DEFINITION of Floater
A floater is a bond or other type of debt whose coupon rate changes with market conditions (short-term interest rates).
A floater is also known as floating-rate debt.
BREAKING DOWN Floater
A floater is a fixed income security that makes coupon payments that are tied to a reference rate. The coupon payments are adjusted following changes in the prevailing interest rates in the economy. When interest rates rise, the value of the coupons is increased to reflect the higher rate. Possible reference or benchmark rates include the London Interbank Offer Rate (LIBOR), Euro Interbank Offer Rate (EURIBOR), federal funds rate, US Treasury rates, etc. For example, a floater bond may have the coupon rate set at "3-month T-bill rate plus 0.5%." 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 lies in contrast to a fixed-rate note, which pays the same interest rate for its entire maturity. Because floaters are based on short-term interest rates, which are generally lower than long-term rates, a floater typically pays lower interest than a fixed-rate note of the same maturity.
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. For this reason, floaters carry lower yields than fixed notes of the same maturity as investors may be willing to accept a lower initial rate in exchange for the possibility of a higher rate if market rates rise. Conversely, a floater is less advantageous to the holder when rates are decreasing because the rate at which they will receive interest declines.
A government or corporate issuer may pay coupons on a floater monthly, quarterly, semi-annually, or annually. The coupon payments are unpredictable, although the security may have a cap and a floor, which allows an investor to know the maximum and/or minimum interest rate the note might pay. A cap is the maximum interest rate that the note can pay, regardless of how high the benchmark rate climbs, and a floor is the lowest allowable payment. A floater’s interest rate can change as often or as frequently as the issuer chooses, from once a day to once a year. The reset period tells the investor how often the rate adjusts.
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 debtholder. 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, the floor is set at zero.