What is an Inverse Floater
An inverse floater is a bond or other type of debt whose coupon rate has an inverse relationship to a benchmark rate. An inverse floater adjusts its coupon payment as the interest rate changes.
An inverse floater is also known as an inverse floating rate note.
BREAKING DOWN Inverse Floater
A floating rate note (FRN), or 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), prime rate, US Treasury rates, etc.
On the other hand, an inverse floating rate note, or inverse floater, works in the opposite way. The coupon rate on the note varies inversely with the benchmark interest rate. Inverse floaters come about through the separation of fixed-rate bonds into two classes: a floater, which moves directly with some interest rate index, and an inverse floater, which represents the residual interest of the fixed-rate bond, net of the floating-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 given that 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.
The general formula for the coupon rate of an inverse floater can be expressed as:
Floating rate = Fixed rate – (Coupon leverage x Reference rate)
---where the coupon leverage is the multiple by which the coupon rate will change for a 100 basis point (bps) change in the reference rate, and the fixed rate is the maximum rate the floater can realize.
A typical inverse floater might be stated to mature in three years, pay interest quarterly, and include a floating rate of 7% minus two times the 3-month LIBOR. In this case, when LIBOR goes up the rate of the bond’s payments go down. 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.
An investor would want to invest in an inverse floater if the benchmark rate is high and s/he believes the rate will decrease in the future at a faster rate than the forwards show. Another strategy is to buy an interest rate floater if the rates are low now and it is expected that they stay low, even though the forwards are implying an increase. If the investor is correct and the rates do not change, s/he will outperform the floating rate note by holding the inverse floater.
As with all investments that employ leverage, inverse floaters introduce a significant amount of interest rate risk. When short-term interest rates fall, both the market price and the yield of the inverse floater increases, magnifying the fluctuation in the bond's price. On the other hand, when short-term interest rates rise, the value of the bond can drop significantly, and holders of this type of instrument may end up with a security that pays little interest. Thus, interest rate risk is magnified and contains a high degree of volatility.